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slides05 - Demand and Supply for Financial Assets...

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Unformatted text preview: Demand and Supply for Financial Assets Applications • Demand & Supply framework applies to: 1. Relative Price Changes (Example: “Flight to Quality”) 2. The Term structure of interest rates: (Mishkin ch.6, part 2, later) 3. The Risk structure of interest rates: (Mishkin ch.6, part 1) 4. Famous “Crash” Events, such as: Black Monday – October 19, 1987. The Flash Crash – May 6, 2010, 2:45pm. 5. The Market for Foreign Exchange (Mishkin ch.17) [Demand&Supply Applications - P.1] The Risk Structure of Interest Rates Well-known Measures of Risk: Bond Ratings [Demand&Supply Applications - P.2] Direct Application of Demand Theory • Increase in risk => Corporate yields should rise relative to Treasury yields • What about other disturbances (e.g. expected inflation)? => Same response [Demand&Supply Applications - P.3] Observations • Yield differences (spreads) match the ranking of relative risks - Spread tend to increase when risk increases (e.g. Great Depression) • Yields move together otherwise => Justification for macroeconomic analysis: - Justified use Treasury bond as benchmark for the overall bond market [Demand&Supply Applications - P.4] Black Monday, Oct.19, 1987 10/14-10/16: 10% down: ~2500 to ~2250 10/19: 25% down: ~2259 to ~1740 10/20-AM: Market shut-down. PM: recovery • Causes: Any changes in expected return, risk, liquidity? • Repeat: 5/6/10 “Flash Crash” 10868 to 9869.62, down 998.5 (9.2%) [Demand&Supply Applications - P.5] The Market for Foreign Exchange • Downward sloping demand: E = Foreign currency (Euro, yen …) per US$ High E = High price of U.S. assets for foreign investors. • Supply essentially fixed in the short run => vertical supply curve. [Demand&Supply Applications - P.6] Scenario: Increase in U.S. Interest Rates • Find: More demand for dollar assets => Exchange rate up. • Lesson: Exchanges rates are sensitive to interest rate changes/Fed policy. [Demand&Supply Applications - P.7] ...
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