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Unformatted text preview: More on bond risk Finishing Chapter 8 Knowledge in financial markets In financial markets, there are usually enough knowledgeable people that markets adjust to equilibrium Examples If the inflation rate goes up, the nominal interest rate will also go up If expected dividends go down on a stock in the future, the value of that stock will also go down More on stocks later today and in the next lecture Irving Fisher American economist Lived 18671947 Influential mathematical economist Hypothesized how much interest rates will change with inflation Photo from the Library of Congress, accessed from http://en.wikipedia.org/wiki/File:Ir vingfisher.jpg The Fisher effect A rise in the rate of inflation causes the nominal rate to rise just enough so that the real rate of interest is unaffected In other words, the real rate is invariant to the rate of inflation From Ross/Westerfield/Jaffe (p. 256) Evidence in favor of the Fisher effect Over the last five decades, the relation between oneyear treasury bond yields and inflation are highly correlated See Figure 8.5, p. 256 Some bonds are explicitly related to inflation Known as inflationlinked bonds Evidence against the Fisher effect There are times when bond yields and inflation diverge August 2011 (annual effective interest rates) Inflation rate 3.8% Oneyear bond yields about 0.1% We sometimes see deflation (i.e. negative inflation) Bond yields must be above rate of inflation 10.85% inflation in 1921 10.30% inflation in 1932 2.1% inflation in July 2009 (0.34% for all of 2009) Inflation information from inflationdata.com Behavioral finance How do people react to financial news? We will discuss this in more details when we get into behavioral finance Section 14.5, part of Unit 4 A typical yield curve Source: http://en.wikipedia.org/wiki/File:USD_yield_curve_09_02_2005.JPG How to determine the nominal interest rate Inflation in Feb. 2005 3.01% Lets assume that the real interest rate for shortterm bonds is 0% The inflation premium is 3% Nominal interest rate Inflation rate How to determine the nominal interest rate Inflation premium changes over time We expect the inflation premium to increase over time here, since we expect longrun inflation to be higher than in 2005 26% most years in the last 30 years We will assume that the longrun inflation premium to be about 4% How to determine the nominal interest rate Interest rate risk premium increases over time...
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 Fall '08
 Lim
 Inflation

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