Unformatted text preview: Demand and Supply for Financial Assets
• 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
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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