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Okay, so let me let me continue with the

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the topic of the previous lecture, which

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is asset pricing.

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And we said the the tricky thing with

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asset pricing is that

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the payoff

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of having an asset comes in the future.

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And that that that implies

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at least two things.

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The first one is that

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we need to have a method to value

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returns in the future

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as of today.

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Okay? So, what is the equivalent to?

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After all, if you want to buy a

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financial asset, you need to pay for it

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today with dollars of today, and you are

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expected to receive some payoff in the

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future. You need to be able to compare

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these two things.

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And the second is that is related is

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that because this payoff is in the

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future, you need to have expectations

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about it. Okay? So, those are the two

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concepts

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we play with.

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Um

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and and the and and there's a third

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related concept, which is because it

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comes in the future, many things can

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happen in between, and so there's also a

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concept of risk. Okay? Those are the

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three

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elements we discuss.

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And

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remember we did I'm going to go very

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quickly over what we did in the previous

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lecture because I could see some faces.

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Uh so so let me go quickly over that and

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then then continue with equity, uh which

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was the next step. Um

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So, the first step was says, "Okay,

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ignore the expectations part for now and

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risk and so on. Assume that you know the

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future." And we ask the question,

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uh well, how do we value a dollar next

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year?

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Uh and in particular, do we want the

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question, is it equivalent to having a

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dollar today?

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And the answer quickly became no because

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imagine that you had the dollar today,

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then you can invest it for a year and

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you get the return of the

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the one-year interest rate return.

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So, with $1 today, you can do more than

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with $1 in the future.

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In fact, that calculation

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gave us the exact recipe to

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valuing a dollar in the future because

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in order to get a dollar in the future,

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I don't need a dollar today. I need one

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over one plus the interest rate.

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Uh I invest this in in the one-year

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bond, uh and and I get a return of that

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over that amount, that gives you exactly

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a dollar in the future. Okay? So, that

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gives us a very natural way of valuing a

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dollar next year, it's just one over one

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plus the interest rate. And by the same

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logic, if I have a dollar today and I

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want to invest it for two years, well,

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I'm going to earn that interest rate for

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the first year, and then I'm going to

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learn that earn that interest rate on

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the full product, not not on the

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original dollar, in the on the one plus

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IT dollars, I'm going to

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earn one plus IT plus one.

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And and and so I can generate sort of a

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lot of

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you know, if the interest rate is 10% on

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average, a dollar today generates 1.21

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uh dollars two years from now. So, that

85
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tells you by the same logic that one

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over 1.21 dollars

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uh

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today is equivalent to $1 in the future.

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Okay?

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So, then we said, "Let's pick a very

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general asset, an asset that has you

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know, that pays

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ZT dollars

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uh this year, then ZT plus one dollars

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one year from now, ZT plus two dollars

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two years from now, and so on and so

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forth up to n years ahead. Uh well, what

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is the value of that asset today? Well,

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you apply exactly the same logic that we

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apply here for every single uh year in

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the future,

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and you get that's that's the the Let's

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call the present present discounted

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value

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uh

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of those cash flows, that gives you the

107
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value today. Okay? Present discounted,

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those are the discount factors, one over

109
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and then that's the value that you get

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out of that. So, that asset

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has that present discounted value of uh

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future cash flows,

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and uh

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and uh

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that should be more or less the price

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that you are willing to pay for that

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asset. Okay?

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Uh and then we introduce expectations

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and okay, well, but we're talking about

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cash flows in the future, in many cases,

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we don't know. Well, we don't know two

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things. First, we don't know

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what the cash flows may be.

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In a very safe bond, you do know the

125
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cash flow, but but but almost any other

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asset, you don't know exactly the cash

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flows you receive, and you don't know

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what the future interest rates, one-year

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interest rate will be.

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Okay?

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So, that took us to the concept of

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expected present discounted value, in

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which you just replace all the things we

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don't know today for the expectations of

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those things. Okay? So, we don't know

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the cash flows in the future, that's the

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reason

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but we have an expectation,

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that's that's what you put there, and uh

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we don't know the future we know the

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current interest rate, but we don't know

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the less

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than it was when the interest rate was a

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little lower. Okay?

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Okay, and then we look at a two-year

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bond, a bond that pays nothing up to two

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years from now, and we said, "Well, two

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years from now pays 100 and then

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matures." Well, the price of that bond

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will be

151
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you know, this. Okay? And notice that in

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this case, the price of a two-year bond

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at time t goes down if the either of the

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one-year rates goes up. Okay? It can be

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the first this year's one-year rate, or

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then maybe that's the expectation that

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the one-year rate uh

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next year will go up. Okay?

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Good.

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Then I introduce an important concept,

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which is this concept of arbitrage

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pricing.

163
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Okay? Which is

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uh two instruments

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uh

166
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um

167
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should give you sort of the same

168
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interest rate. We're leaving risk

169
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considerations aside. It should give you

170
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the same return

171
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when you compare them

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uh um

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uh over the same maturity. Okay? So,

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in this particular example, I said,

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"Look,

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a one-year bond

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and a two-year bond that you invest you

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hold for only one year should give you

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more or less the same return."

180
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Okay?

181
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So so

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so that means

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that

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this is the return you get from a dollar

185
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invested in a one-year bond,

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okay? Should be equal to the return you

187
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get

188
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by investing in a in a two-year bond and

189
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selling that bond after one year.

190
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And that's the expression we had here.

191
00:07:10,240 --> 00:07:13,680
Okay?

192
00:07:11,120 --> 00:07:16,759
If you this is what you pay for a for a

193
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for a two-year bond, and this is what

194
00:07:16,759 --> 00:07:21,599
you expect uh uh

195
00:07:19,319 --> 00:07:24,120
to to be paid for that bond when you

196
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sell it one year from now. Notice that

197
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one year from now, the two-year bond

198
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will

199
00:09:55,000 --> 00:09:59,840
when you sell it 1 year from now. Notice

200
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that 1 year from now the 2-year bond

201
00:09:59,840 --> 00:10:03,720
will be a 1-year bond because 1 year

202
00:10:02,279 --> 00:10:05,079
will have expired and that point it will

203
00:10:03,720 --> 00:10:08,040
be a 1-year bond. That's the reason we

204
00:10:05,080 --> 00:10:09,840
have a subscript P1T here.

205
00:10:08,039 --> 00:10:13,399
So, that means that we can solve from

206
00:10:09,840 --> 00:10:15,759
here that P2T is simply that.

207
00:10:13,399 --> 00:10:17,879
But there's an expression like the one

208
00:10:15,759 --> 00:10:19,759
we had for the 1-year bond at time T,

209
00:10:17,879 --> 00:10:21,879
there is 1 over T plus 1. We put

210
00:10:19,759 --> 00:10:25,159
expectations because we don't know the

211
00:10:21,879 --> 00:10:29,720
actual interest rate in the future.

212
00:10:25,159 --> 00:10:32,480
And then I stuck this into there and I

213
00:10:29,720 --> 00:10:34,000
we got exactly the same price that we

214
00:10:32,480 --> 00:10:36,720
got with the net present expected

215
00:10:34,000 --> 00:10:38,360
present discounted value approach, okay?

216
00:10:36,720 --> 00:10:40,399
And so, this asset pricing this

217
00:10:38,360 --> 00:10:42,320
arbitrage way of pricing things is an

218
00:10:40,399 --> 00:10:43,799
incredibly powerful tool

219
00:10:42,320 --> 00:10:45,520
that is used very extensively in

220
00:10:43,799 --> 00:10:47,199
finance. This These are simple

221
00:10:45,519 --> 00:10:50,360
calculation, but when assets gets to be

222
00:10:47,200 --> 00:10:54,080
tricky, much more complicated,

223
00:10:50,360 --> 00:10:54,080
this is is very useful.

224
00:10:54,399 --> 00:11:00,039
Then we talk about bond yields.

225
00:10:57,360 --> 00:11:03,399
And bond yields are defined

226
00:11:00,039 --> 00:11:06,000
as the constant interest rate

227
00:11:03,399 --> 00:11:08,639
that

228
00:11:06,000 --> 00:11:11,120
that is consistent with the current

229
00:11:08,639 --> 00:11:14,439
price of that particular bond.

230
00:11:11,120 --> 00:11:16,839
Okay? So, in the case of the 2-year bond

231
00:11:14,440 --> 00:11:19,160
we call the 2-year rate.

232
00:11:16,839 --> 00:11:21,120
That interest rate that is constant over

233
00:11:19,159 --> 00:11:22,559
the two periods.

234
00:11:21,120 --> 00:11:27,600
That's Okay, that's the reason I have

235
00:11:22,559 --> 00:11:29,159
squared it. It's not I1T * 1 I1T + 1.

236
00:11:27,600 --> 00:11:31,200
I squared it.

237
00:11:29,159 --> 00:11:32,559
It's not constant over time. This The

238
00:11:31,200 --> 00:11:34,360
2-year interest rate may be moving a

239
00:11:32,559 --> 00:11:36,199
lot. I mean, the the Fed just hiked by

240
00:11:34,360 --> 00:11:38,680
25 basis points. I'm sure all rates are

241
00:11:36,200 --> 00:11:41,160
moving at this moment. So, the rates can

242
00:11:38,679 --> 00:11:42,919
be moving at all points in time, but

243
00:11:41,159 --> 00:11:44,559
they But we define as the yield is at

244
00:11:42,919 --> 00:11:46,079
one point in time. You tell me the price

245
00:11:44,559 --> 00:11:49,359
of the bond. You tell me the payoff of

246
00:11:46,080 --> 00:11:52,120
the bond, then what is the the the

247
00:11:49,360 --> 00:11:54,519
constant interest rate that makes this

248
00:11:52,120 --> 00:11:57,000
price this expression equal to the

249
00:11:54,519 --> 00:12:00,039
actual price? That's the way we define

250
00:11:57,000 --> 00:12:03,240
the 2-year rate. That's the 2-year rate.

251
00:12:00,039 --> 00:12:05,079
And if you have a bond that pays 100 n

252
00:12:03,240 --> 00:12:08,159
years from now, then there would be a

253
00:12:05,080 --> 00:12:11,240
constant interest rate In n, you know,

254
00:12:08,159 --> 00:12:13,279
that that gives you 100 divided by 1

255
00:12:11,240 --> 00:12:14,039
plus InT

256
00:12:13,279 --> 00:12:15,439
uh

257
00:12:14,039 --> 00:12:17,159
to the n

258
00:12:15,440 --> 00:12:19,560
to the n power

259
00:12:17,159 --> 00:12:22,079
that will give you

260
00:12:19,559 --> 00:12:24,079
that you set that equal to the price the

261
00:12:22,080 --> 00:12:26,960
actual price of the bond, the one you

262
00:12:24,080 --> 00:12:29,520
get out of expected present discounted

263
00:12:26,960 --> 00:12:31,839
value or out of arbitrage, then you have

264
00:12:29,519 --> 00:12:34,480
found the yield or the yield to

265
00:12:31,839 --> 00:12:34,480
maturity.

266
00:12:34,799 --> 00:12:38,199
You know, we know what the We already

267
00:12:36,320 --> 00:12:39,760
got the price from the previous slide.

268
00:12:38,200 --> 00:12:42,600
We know that the price of this bond is

269
00:12:39,759 --> 00:12:44,639
going to be 100 as a 2-year bond

270
00:12:42,600 --> 00:12:47,000
divided by this product of 1 plus

271
00:12:44,639 --> 00:12:48,879
interest rate 1-year interest rate. So,

272
00:12:47,000 --> 00:12:50,879
this has to be equal to that. That's the

273
00:12:48,879 --> 00:12:52,039
way actually you calculate the 2-year

274
00:12:50,879 --> 00:12:52,759
yield.

275
00:12:52,039 --> 00:12:54,838
Uh

276
00:12:52,759 --> 00:12:56,919
and numerators are the same, that means

277
00:12:54,839 --> 00:12:59,640
the denominators have to be the same.

278
00:12:56,919 --> 00:13:02,639
And this implies approximately that the

279
00:12:59,639 --> 00:13:05,399
2-year rate is a sort of average of the

280
00:13:02,639 --> 00:13:08,519
expected 1-year rate, okay?

281
00:13:05,399 --> 00:13:10,919
So, in this case the 2-year rate is a

282
00:13:08,519 --> 00:13:12,679
sort of average of the 1-year rate. That

283
00:13:10,919 --> 00:13:15,039
means that when the

284
00:13:12,679 --> 00:13:17,759
when you expect the interest rate to be

285
00:13:15,039 --> 00:13:19,719
the 1-year rate to be rising over time

286
00:13:17,759 --> 00:13:21,960
then the 2-year rate will be above the

287
00:13:19,720 --> 00:13:23,440
1-year rate today.

288
00:13:21,960 --> 00:13:25,839
That's when the curve is We say the

289
00:13:23,440 --> 00:13:28,680
curve the yield curve is steep. Let me

290
00:13:25,839 --> 00:13:28,680
show you something.

291
00:13:31,480 --> 00:13:36,960
There.

292
00:13:33,159 --> 00:13:38,399
When the curve looks like that, so steep

293
00:13:36,960 --> 00:13:41,800
means that

294
00:13:38,399 --> 00:13:43,559
the the the later the 2-year rate the

295
00:13:41,799 --> 00:13:45,919
3-year Well, here in particular the

296
00:13:43,559 --> 00:13:48,039
3-year rate is the 2-year rate is higher

297
00:13:45,919 --> 00:13:49,399
than the 1-year rate. The 3-year rate is

298
00:13:48,039 --> 00:13:50,480
higher than the 2-year rate and so on

299
00:13:49,399 --> 00:13:54,079
and so forth.

300
00:13:50,480 --> 00:13:55,720
That happens when when you expect the

301
00:13:54,080 --> 00:13:56,759
market expects the interest rate to be

302
00:13:55,720 --> 00:13:59,040
rising

303
00:13:56,759 --> 00:14:02,919
over time. The 1-year rate to be rising,

304
00:13:59,039 --> 00:14:04,480
okay? Because Remember the 2-year rate

305
00:14:02,919 --> 00:14:06,399
is the average of the existing the

306
00:14:04,480 --> 00:14:08,920
current 1-year rate plus the expected

307
00:14:06,399 --> 00:14:10,799
1-year rate 1 year from now.

308
00:14:08,919 --> 00:14:13,000
For that average to be higher than the

309
00:14:10,799 --> 00:14:15,838
1-year rate now, it has to be the case

310
00:14:13,000 --> 00:14:17,360
that the one expected 1-year rate 1 year

311
00:14:15,839 --> 00:14:20,360
from now has to be higher than the

312
00:14:17,360 --> 00:14:22,360
current 1-year rate. Okay? So, that's

313
00:14:20,360 --> 00:14:23,480
what you tend to get uh

314
00:14:22,360 --> 00:14:25,800
that's when you get to the upward

315
00:14:23,480 --> 00:14:27,320
sloping term structure. And when you get

316
00:14:25,799 --> 00:14:29,120
a downward sloping term structure, which

317
00:14:27,320 --> 00:14:31,200
is the way it looks right now, actually

318
00:14:29,120 --> 00:14:32,919
right now looks very downward sloping.

319
00:14:31,200 --> 00:14:35,879
There you are. You know, it looks very

320
00:14:32,919 --> 00:14:38,000
downward sloping. Is people expect that

321
00:14:35,879 --> 00:14:40,480
we're getting to the peak of current

322
00:14:38,000 --> 00:14:42,399
policy rate of short-term interest rate.

323
00:14:40,480 --> 00:14:45,079
And so, people expect now for the

324
00:14:42,399 --> 00:14:46,600
interest rate to decline going forward.

325
00:14:45,078 --> 00:14:50,559
And that's the reason

326
00:14:46,600 --> 00:14:53,600
the the the 2-year rate now is lower

327
00:14:50,559 --> 00:14:55,119
than the 1-year rate.

328
00:14:53,600 --> 00:14:58,240
And the 5-year rate is lower than the

329
00:14:55,120 --> 00:14:58,240
2-year rate and so on.

330
00:14:59,480 --> 00:15:05,639
Uh as you can see here, it's very steep.

331
00:15:02,639 --> 00:15:08,078
Okay. Then we said, "Well, let's add

332
00:15:05,639 --> 00:15:10,519
risk because here Sure, here we assume

333
00:15:08,078 --> 00:15:12,479
that you were indifferent between

334
00:15:10,519 --> 00:15:13,759
investing in a completely safe 1-year

335
00:15:12,480 --> 00:15:15,680
bond

336
00:15:13,759 --> 00:15:17,000
and a and a 2-year bond in which you

337
00:15:15,679 --> 00:15:18,639
have to make an expectation about the

338
00:15:17,000 --> 00:15:20,759
price, but that price could move around.

339
00:15:18,639 --> 00:15:22,480
So, there's risk on that price or the on

340
00:15:20,759 --> 00:15:25,000
the price of 1-year

341
00:15:22,480 --> 00:15:25,720
bond the 1-year bond

342
00:15:25,000 --> 00:15:27,519
uh

343
00:15:25,720 --> 00:15:31,120
as of today.

344
00:15:27,519 --> 00:15:33,039
And then and so

345
00:15:31,120 --> 00:15:35,078
So, we added risk. And there are two

346
00:15:33,039 --> 00:15:37,599
type of risk in bonds. One is default

347
00:15:35,078 --> 00:15:39,439
risk that, you know, that that they had

348
00:15:37,600 --> 00:15:41,519
promised they would pay you 100, but it

349
00:15:39,440 --> 00:15:43,440
may it may be happen that they cannot

350
00:15:41,519 --> 00:15:45,480
pay you the 100. The corporation or the

351
00:15:43,440 --> 00:15:48,160
government or so on. Argentina defaults

352
00:15:45,480 --> 00:15:50,200
in its bonds regularly, okay?

353
00:15:48,159 --> 00:15:53,039
Uh for example. Uh

354
00:15:50,200 --> 00:15:54,839
many of the of the of the

355
00:15:53,039 --> 00:15:57,159
regional banks that had gone under will

356
00:15:54,839 --> 00:15:59,040
default on their bonds as well, okay?

357
00:15:57,159 --> 00:16:01,360
So, that kind of risk. But we remove

358
00:15:59,039 --> 00:16:02,759
that risk and we'll focus for now on the

359
00:16:01,360 --> 00:16:04,360
I'm going to focus mostly on the price

360
00:16:02,759 --> 00:16:06,559
risk because I'm going to be talking

361
00:16:04,360 --> 00:16:08,639
mostly about US Treasury bonds. US

362
00:16:06,559 --> 00:16:10,599
Treasury bonds have no default risk, we

363
00:16:08,639 --> 00:16:13,559
think. I mean, there could be an event

364
00:16:10,600 --> 00:16:15,639
in a few weeks from now, but no one

365
00:16:13,559 --> 00:16:18,439
expects that to be a lasting event. I

366
00:16:15,639 --> 00:16:20,480
mean, if it is, there's a real mess, but

367
00:16:18,440 --> 00:16:22,320
But anyway, but there is also price risk

368
00:16:20,480 --> 00:16:24,240
because you have to hold this and then

369
00:16:22,320 --> 00:16:25,800
sell it at the end of 1 year and you

370
00:16:24,240 --> 00:16:27,919
don't know exactly the price what the

371
00:16:25,799 --> 00:16:29,399
price will be. Okay? There's a risk

372
00:16:27,919 --> 00:16:32,399
associated to that.

373
00:16:29,399 --> 00:16:34,159
So, so that means that really you

374
00:16:32,399 --> 00:16:37,039
shouldn't equalize the return on the

375
00:16:34,159 --> 00:16:40,159
1-year bond to the return you expect to

376
00:16:37,039 --> 00:16:42,599
get in in the 2-year bond. You should

377
00:16:40,159 --> 00:16:44,240
add a little compensation for holding

378
00:16:42,600 --> 00:16:47,159
the 2-year bond, for going the 2-year

379
00:16:44,240 --> 00:16:50,600
bond route, okay? And so, rather than

380
00:16:47,159 --> 00:16:51,480
expect to make 1 plus I1T

381
00:16:50,600 --> 00:16:54,159
uh

382
00:16:51,480 --> 00:16:56,399
with with the 2-year bond after 1 year,

383
00:16:54,159 --> 00:16:57,480
you should expect to earn a little more,

384
00:16:56,399 --> 00:17:00,639
okay?

385
00:16:57,480 --> 00:17:03,759
And that's what this XB being positive

386
00:17:00,639 --> 00:17:05,759
reflects. And so, in that case the price

387
00:17:03,759 --> 00:17:07,720
the price of the 2-year bond is a little

388
00:17:05,759 --> 00:17:09,519
different from what we had. In fact,

389
00:17:07,720 --> 00:17:10,880
it's a little lower than what we had

390
00:17:09,519 --> 00:17:12,920
because that's the way you compensate

391
00:17:10,880 --> 00:17:14,520
for risk. I sell you an instrument a

392
00:17:12,920 --> 00:17:16,400
little cheaper than it would have been

393
00:17:14,519 --> 00:17:18,519
in the absence of risk,

394
00:17:16,400 --> 00:17:20,560
so you you expect to get a little a

395
00:17:18,519 --> 00:17:23,599
slightly higher return out of that,

396
00:17:20,559 --> 00:17:26,240
okay? So, this price is lower than the

397
00:17:23,599 --> 00:17:28,159
price without the risk premium here.

398
00:17:26,240 --> 00:17:30,679
No? That means but it's still is

399
00:17:28,160 --> 00:17:32,440
promising you 100, so that's exactly how

400
00:17:30,679 --> 00:17:33,720
you get more return out of it because

401
00:17:32,440 --> 00:17:34,720
you were buying something at a lower

402
00:17:33,720 --> 00:17:37,039
price.

403
00:17:34,720 --> 00:17:37,039
Okay?

404
00:17:43,839 --> 00:17:49,240
So, I can do the same logic now and see

405
00:17:46,559 --> 00:17:50,678
what the 2-year rate is, but now that I

406
00:17:49,240 --> 00:17:52,960
have this

407
00:17:50,679 --> 00:17:55,120
taking to account this risk and you have

408
00:17:52,960 --> 00:17:57,679
that the 2-year rate now is the average

409
00:17:55,119 --> 00:18:00,359
not only of the expected 1-year rate,

410
00:17:57,679 --> 00:18:01,360
but also includes a risk premium.

411
00:18:00,359 --> 00:18:03,559
Okay?

412
00:18:01,359 --> 00:18:05,079
And so, and that tends to be the case

413
00:18:03,559 --> 00:18:06,519
that the the further out in the curve

414
00:18:05,079 --> 00:18:09,079
you are, the larger is that risk

415
00:18:06,519 --> 00:18:11,160
premium. It's called term premium

416
00:18:09,079 --> 00:18:13,359
because term is the same as maturity,

417
00:18:11,160 --> 00:18:13,360
okay?

418
00:18:13,799 --> 00:18:16,279
Um

419
00:18:16,799 --> 00:18:20,240
Actually

420
00:18:18,640 --> 00:18:21,120
sometimes that that is negative,

421
00:18:20,240 --> 00:18:23,200
actually.

422
00:18:21,119 --> 00:18:25,479
May and and recently up to very

423
00:18:23,200 --> 00:18:28,679
recently. Now it's positive. But until

424
00:18:25,480 --> 00:18:29,960
very recently that XB was negative.

425
00:18:28,679 --> 00:18:32,280
And the reason for that, you don't need

426
00:18:29,960 --> 00:18:35,039
to understand that now, is because

427
00:18:32,279 --> 00:18:37,240
long-term bonds were great hedges.

428
00:18:35,039 --> 00:18:39,599
Uh meaning meaning, you know, if there

429
00:18:37,240 --> 00:18:42,200
is a for any major event, for a

430
00:18:39,599 --> 00:18:44,918
financial crisis or something like that,

431
00:18:42,200 --> 00:18:46,240
because in a financial crisis or a major

432
00:18:44,919 --> 00:18:49,080
disaster

433
00:18:46,240 --> 00:18:50,839
interest rates tend to fall.

434
00:18:49,079 --> 00:18:52,599
And when interest rates fall, the price

435
00:18:50,839 --> 00:18:55,000
of bonds go up.

436
00:18:52,599 --> 00:18:57,199
Okay? And and so so that was a good

437
00:18:55,000 --> 00:18:58,880
hedge. If you wanted to to protect your

438
00:18:57,200 --> 00:19:02,080
your portfolio of equities and so on

439
00:18:58,880 --> 00:19:04,720
against a major catastrophic major event

440
00:19:02,079 --> 00:19:06,839
like a financial crisis or, you know, a

441
00:19:04,720 --> 00:19:08,880
war or something like that, it was not a

442
00:19:06,839 --> 00:19:12,439
bad idea to have some long-term US

443
00:19:08,880 --> 00:19:14,400
Treasury bonds in your portfolio because

444
00:19:12,440 --> 00:19:16,000
they would tend to go up precisely when

445
00:19:14,400 --> 00:19:17,800
everything else was going to be losing

446
00:19:16,000 --> 00:19:19,919
money, okay? And so, that's the reason

447
00:19:17,799 --> 00:19:21,960
tend to be negative. Now that's not the

448
00:19:19,919 --> 00:19:23,600
case because now one of the biggest risk

449
00:19:21,960 --> 00:19:26,279
is inflation.

450
00:19:23,599 --> 00:19:27,519
And so so uh if there's an inflationary

451
00:19:26,279 --> 00:19:29,918
spike,

452
00:19:27,519 --> 00:19:31,599
then interest rate will go down up, not

453
00:19:29,919 --> 00:19:33,360
down. And that means the price of bonds

454
00:19:31,599 --> 00:19:35,000
will decline. So, they will decline at

455
00:19:33,359 --> 00:19:36,678
the wrong time,

456
00:19:35,000 --> 00:19:38,919
So, the price of bonds of long-term

457
00:19:36,679 --> 00:19:40,280
bonds now will tend to decline

458
00:19:38,919 --> 00:19:42,040
uh when everything else is also

459
00:19:40,279 --> 00:19:43,599
plummeting. I mean, if we get a negative

460
00:19:42,039 --> 00:19:45,200
if we get an inflation surprise that

461
00:19:43,599 --> 00:19:47,439
inflation is a lot higher than people

462
00:19:45,200 --> 00:19:49,440
expected, asset prices are going to

463
00:19:47,440 --> 00:19:51,480
decline, all of them, including

464
00:19:49,440 --> 00:19:55,480
long-term bonds. And that's the reason

465
00:19:51,480 --> 00:19:55,480
now this XB is positive.

466
00:19:56,119 --> 00:20:01,279
Okay, so that's I think that's where we

467
00:19:58,119 --> 00:20:02,879
were at in the previous lecture.

468
00:20:01,279 --> 00:20:06,720
Any questions about that? Then I'm going

469
00:20:02,880 --> 00:20:07,840
to Next step is to talk about equity.

470
00:20:06,720 --> 00:20:08,600
No?

471
00:20:07,839 --> 00:20:10,879
Yeah.

472
00:20:08,599 --> 00:20:12,319
Why don't we add the interest the risk

473
00:20:10,880 --> 00:20:14,640
to the interest rate for the one year

474
00:20:12,319 --> 00:20:14,639
now?

475
00:20:15,680 --> 00:20:19,680
Well, because next year that one for

476
00:20:17,720 --> 00:20:23,360
this particular bond

477
00:20:19,680 --> 00:20:25,320
that that bond will have no risk because

478
00:20:23,359 --> 00:20:26,439
it will be one year to go

479
00:20:25,319 --> 00:20:28,799
and at the end of that year you're going

480
00:20:26,440 --> 00:20:30,799
to get the 100.

481
00:20:28,799 --> 00:20:32,799
So, there's no risk that added. If it

482
00:20:30,799 --> 00:20:35,039
was a three-year bond, then you would

483
00:20:32,799 --> 00:20:36,240
have in two of those you would have risk

484
00:20:35,039 --> 00:20:37,680
premium.

485
00:20:36,240 --> 00:20:38,920
And but you wouldn't have it in the last

486
00:20:37,680 --> 00:20:40,360
one because in the last one you don't

487
00:20:38,920 --> 00:20:42,080
have the you're going to receive the

488
00:20:40,359 --> 00:20:45,559
100.

489
00:20:42,079 --> 00:20:47,480
If the bond could could could default

490
00:20:45,559 --> 00:20:48,919
so because I'm only looking at price

491
00:20:47,480 --> 00:20:49,839
risk in the bond.

492
00:20:48,920 --> 00:20:52,519
Uh uh

493
00:20:49,839 --> 00:20:54,639
if the bond could could default, then I

494
00:20:52,519 --> 00:20:56,359
would add an extra

495
00:20:54,640 --> 00:20:58,520
term there because it's the fall risk.

496
00:20:56,359 --> 00:21:00,879
But but here I'm just looking at price

497
00:20:58,519 --> 00:21:03,319
risk and I'm assuming the the unit of

498
00:21:00,880 --> 00:21:05,240
time is one year. So, just one year

499
00:21:03,319 --> 00:21:07,599
before it expires there's no more risk

500
00:21:05,240 --> 00:21:10,079
because there's no price in between

501
00:21:07,599 --> 00:21:11,039
and and you're going to receive a 100

502
00:21:10,079 --> 00:21:14,000
uh uh

503
00:21:11,039 --> 00:21:16,599
at the end of the year. In reality

504
00:21:14,000 --> 00:21:17,880
time is continuous. So, so every second

505
00:21:16,599 --> 00:21:19,319
there's a little bit of a risk. So, you

506
00:21:17,880 --> 00:21:21,240
have a little bit of that risk all the

507
00:21:19,319 --> 00:21:23,240
time except for the last second.

508
00:21:21,240 --> 00:21:24,960
Uh but but

509
00:21:23,240 --> 00:21:26,039
I'm looking at a simple example where

510
00:21:24,960 --> 00:21:29,400
you know

511
00:21:26,039 --> 00:21:29,399
things happen every one year. And

512
00:21:31,480 --> 00:21:35,039
In the book I think they mess up

513
00:21:33,480 --> 00:21:37,759
actually. They put the risk premium in

514
00:21:35,039 --> 00:21:40,200
the wrong place. But

515
00:21:37,759 --> 00:21:41,839
there was another question.

516
00:21:40,200 --> 00:21:44,000
No?

517
00:21:41,839 --> 00:21:44,959
Okay.

518
00:21:44,000 --> 00:21:47,480
So

519
00:21:44,960 --> 00:21:49,000
let's look at the stock prices now.

520
00:21:47,480 --> 00:21:50,559
Uh

521
00:21:49,000 --> 00:21:53,440
So, a stock price has two key

522
00:21:50,559 --> 00:21:55,519
differences with respect to

523
00:21:53,440 --> 00:21:55,519
um

524
00:21:56,000 --> 00:21:59,599
Well, certainly there were but two that

525
00:21:57,319 --> 00:22:01,119
I want to highlight.

526
00:21:59,599 --> 00:22:02,639
The first is that they don't pay

527
00:22:01,119 --> 00:22:05,039
coupons, fixed amount. They don't

528
00:22:02,640 --> 00:22:07,360
promise you to pay, you know, $100 two

529
00:22:05,039 --> 00:22:09,639
years from now or anything like that.

530
00:22:07,359 --> 00:22:10,759
They pay dividends.

531
00:22:09,640 --> 00:22:12,720
Okay?

532
00:22:10,759 --> 00:22:14,559
They tell you we have a policy of paying

533
00:22:12,720 --> 00:22:16,679
dividends and even different companies

534
00:22:14,559 --> 00:22:18,599
differentiate themselves by how much

535
00:22:16,679 --> 00:22:20,960
they promise to give you on average in

536
00:22:18,599 --> 00:22:22,799
dividends, but it's a promise that if

537
00:22:20,960 --> 00:22:24,360
everything goes as planned, they'll pay

538
00:22:22,799 --> 00:22:26,720
you those dividends.

539
00:22:24,359 --> 00:22:28,799
It's not a commitment to pay you a

540
00:22:26,720 --> 00:22:30,880
dividend. When it's very different from

541
00:22:28,799 --> 00:22:33,759
a bond. A bond says, "I'll pay you a

542
00:22:30,880 --> 00:22:35,080
coupon of this amount every six months."

543
00:22:33,759 --> 00:22:37,079
And if you don't pay that coupon, that's

544
00:22:35,079 --> 00:22:38,720
a default.

545
00:22:37,079 --> 00:22:41,279
There's nothing like that in equity.

546
00:22:38,720 --> 00:22:43,000
Equity you buy shares of Apple and you

547
00:22:41,279 --> 00:22:45,799
sort of look at the history of dividend,

548
00:22:43,000 --> 00:22:49,240
what what the CEO told you the last time

549
00:22:45,799 --> 00:22:50,720
the in the last release uh and and and

550
00:22:49,240 --> 00:22:51,839
you know, you you can you you think,

551
00:22:50,720 --> 00:22:52,799
"Okay, these are more or less going to

552
00:22:51,839 --> 00:22:55,119
be my dividends." But there's no

553
00:22:52,799 --> 00:22:57,039
commitment.

554
00:22:55,119 --> 00:22:58,759
They will always tell you

555
00:22:57,039 --> 00:23:00,480
what's their plan

556
00:22:58,759 --> 00:23:01,879
but it's a plan. It's not a commitment.

557
00:23:00,480 --> 00:23:03,279
So, that's the first thing. It doesn't

558
00:23:01,880 --> 00:23:05,320
have fixed coupons or anything like

559
00:23:03,279 --> 00:23:07,279
that. There's no commitment. And in that

560
00:23:05,319 --> 00:23:08,678
sense there's no sense of default

561
00:23:07,279 --> 00:23:10,160
because there was no commitment, so

562
00:23:08,679 --> 00:23:13,080
there's no default.

563
00:23:10,160 --> 00:23:15,560
Uh if if a company has to cut dividends

564
00:23:13,079 --> 00:23:16,399
to zero, that's not a default.

565
00:23:15,559 --> 00:23:17,960
That's

566
00:23:16,400 --> 00:23:20,000
conditions change. That's it. There was

567
00:23:17,960 --> 00:23:21,200
no commitment to that.

568
00:23:20,000 --> 00:23:23,240
The second

569
00:23:21,200 --> 00:23:25,160
feature is that they don't have a fixed

570
00:23:23,240 --> 00:23:28,079
terminal date.

571
00:23:25,160 --> 00:23:29,600
99.9999999%

572
00:23:28,079 --> 00:23:31,199
of the bonds do have a terminal date.

573
00:23:29,599 --> 00:23:32,759
They have a maturity. I mean, there's a

574
00:23:31,200 --> 00:23:34,679
few exceptions which are called

575
00:23:32,759 --> 00:23:36,960
perpetuities.

576
00:23:34,679 --> 00:23:39,880
That I think the US has none for

577
00:23:36,960 --> 00:23:40,799
example. But but but but most bonds have

578
00:23:39,880 --> 00:23:42,880
a

579
00:23:40,799 --> 00:23:44,079
uh uh a a maturity.

580
00:23:42,880 --> 00:23:46,040
Okay?

581
00:23:44,079 --> 00:23:47,879
Equity doesn't come that way. Nobody

582
00:23:46,039 --> 00:23:50,399
tells you buy a share of Apple you don't

583
00:23:47,880 --> 00:23:52,560
buy shares of Apple that

584
00:23:50,400 --> 00:23:54,560
they will that will be retired 30 years

585
00:23:52,559 --> 00:23:56,159
from now. Okay?

586
00:23:54,559 --> 00:23:57,919
They will be there as long as Apple's

587
00:23:56,160 --> 00:23:58,960
exist.

588
00:23:57,920 --> 00:24:00,039
Okay?

589
00:23:58,960 --> 00:24:02,120
Uh

590
00:24:00,039 --> 00:24:04,200
Now, of course, you know, if you had

591
00:24:02,119 --> 00:24:05,599
shares of First Republic Bank, you have

592
00:24:04,200 --> 00:24:07,960
nothing now.

593
00:24:05,599 --> 00:24:09,639
And because of that but but that was not

594
00:24:07,960 --> 00:24:12,160
the original plan. If First Republic

595
00:24:09,640 --> 00:24:13,600
Bank had been successful, you would have

596
00:24:12,160 --> 00:24:15,720
the the shares would have survived for a

597
00:24:13,599 --> 00:24:18,199
very long period of time. Okay?

598
00:24:15,720 --> 00:24:19,880
So so there's no sense of maturity. In

599
00:24:18,200 --> 00:24:22,360
principle

600
00:24:19,880 --> 00:24:24,480
equity can last forever.

601
00:24:22,359 --> 00:24:24,479
Okay?

602
00:24:27,480 --> 00:24:33,240
So, I'm going to use arbitrage to to to

603
00:24:30,759 --> 00:24:34,440
price equity.

604
00:24:33,240 --> 00:24:35,200
So

605
00:24:34,440 --> 00:24:37,480
uh

606
00:24:35,200 --> 00:24:38,640
let me So, let's we have the following

607
00:24:37,480 --> 00:24:40,599
uh

608
00:24:38,640 --> 00:24:41,400
portfolio of options here.

609
00:24:40,599 --> 00:24:44,480
Uh

610
00:24:41,400 --> 00:24:45,800
one is our old one-year bond.

611
00:24:44,480 --> 00:24:48,440
Okay? So, you can invest your dollar

612
00:24:45,799 --> 00:24:49,960
today in a one-year bond.

613
00:24:48,440 --> 00:24:51,840
The alternative I'm going to say there

614
00:24:49,960 --> 00:24:55,000
is some equity out there. And I'm going

615
00:24:51,839 --> 00:24:57,720
to call the price of that equity Q

616
00:24:55,000 --> 00:25:01,679
and the dividend of that e- e-

617
00:24:57,720 --> 00:25:01,679
equity D. Okay?

618
00:25:01,720 --> 00:25:06,079
So

619
00:25:03,920 --> 00:25:07,960
so let's price this stock by by

620
00:25:06,079 --> 00:25:09,480
arbitrage. So

621
00:25:07,960 --> 00:25:12,279
equity is risky.

622
00:25:09,480 --> 00:25:14,880
I mean, that is much riskier than than

623
00:25:12,279 --> 00:25:16,399
than than bonds unless you are into

624
00:25:14,880 --> 00:25:17,720
Argentinian bonds or things like that.

625
00:25:16,400 --> 00:25:18,759
But I mean, it's much riskier than

626
00:25:17,720 --> 00:25:20,759
bonds.

627
00:25:18,759 --> 00:25:22,879
So, there's always a risk premium and

628
00:25:20,759 --> 00:25:25,559
actually that itself is a trade. You

629
00:25:22,880 --> 00:25:28,360
trade the risk premium of equity market.

630
00:25:25,559 --> 00:25:30,039
So, I'm going to put an XS here. So what

631
00:25:28,359 --> 00:25:31,479
do you what do you expect to get from

632
00:25:30,039 --> 00:25:33,159
from holding

633
00:25:31,480 --> 00:25:35,759
Remember, arbitrage means the same

634
00:25:33,160 --> 00:25:39,480
holding period. So, I'm going to compare

635
00:25:35,759 --> 00:25:41,079
investing in a one-year safe bond

636
00:25:39,480 --> 00:25:44,319
versus

637
00:25:41,079 --> 00:25:46,519
buying equity today, buying a stock

638
00:25:44,319 --> 00:25:48,319
holding it for a year

639
00:25:46,519 --> 00:25:50,759
and then selling it there.

640
00:25:48,319 --> 00:25:52,720
Okay? That because that's That's I

641
00:25:50,759 --> 00:25:54,400
cannot do arbitrage for paying different

642
00:25:52,720 --> 00:25:55,759
holding periods. That's a one-year

643
00:25:54,400 --> 00:25:57,519
holding period.

644
00:25:55,759 --> 00:25:59,400
So, I'm saying this is what I'm going to

645
00:25:57,519 --> 00:26:01,200
get from the bond. I'm going to require

646
00:25:59,400 --> 00:26:03,840
some risk compensation for that because

647
00:26:01,200 --> 00:26:05,679
risk equity is risky. So, I'm going to

648
00:26:03,839 --> 00:26:07,639
want that. And this is what I'm going to

649
00:26:05,679 --> 00:26:09,080
get That's my return on equity I get.

650
00:26:07,640 --> 00:26:10,360
This is what I'm going to pay today for

651
00:26:09,079 --> 00:26:12,199
the stock

652
00:26:10,359 --> 00:26:13,919
say for a share of Apple

653
00:26:12,200 --> 00:26:16,240
and I'm going to get this. This is the

654
00:26:13,920 --> 00:26:18,000
dividend I expect to get

655
00:26:16,240 --> 00:26:19,559
at the end of the year

656
00:26:18,000 --> 00:26:21,839
and then I this is the price at which I

657
00:26:19,559 --> 00:26:23,359
expect to sell

658
00:26:21,839 --> 00:26:24,678
that share

659
00:26:23,359 --> 00:26:25,479
one year from now.

660
00:26:24,679 --> 00:26:27,360
Okay?

661
00:26:25,480 --> 00:26:30,079
So, that's the return I'm expecting to

662
00:26:27,359 --> 00:26:31,479
get from holding the share of Apple for

663
00:26:30,079 --> 00:26:32,119
one period.

664
00:26:31,480 --> 00:26:33,839
Okay?

665
00:26:32,119 --> 00:26:35,519
And that's what I need to compare with

666
00:26:33,839 --> 00:26:38,399
holding for one year

667
00:26:35,519 --> 00:26:40,440
one-year bond. But I want also to be

668
00:26:38,400 --> 00:26:42,000
compensated uh

669
00:26:40,440 --> 00:26:44,519
for uh

670
00:26:42,000 --> 00:26:46,880
risk. Okay?

671
00:26:44,519 --> 00:26:46,879
Good.

672
00:26:47,000 --> 00:26:49,679
Is this clear?

673
00:26:51,240 --> 00:26:53,079
Okay,

674
00:26:51,880 --> 00:26:54,560
good.

675
00:26:53,079 --> 00:26:56,279
I don't know whether silence means yes

676
00:26:54,559 --> 00:26:57,839
or no. But this is

677
00:26:56,279 --> 00:26:59,720
No, we did something like this with the

678
00:26:57,839 --> 00:27:02,319
two-year bond except that we didn't have

679
00:26:59,720 --> 00:27:04,799
a a dividend there, you know,

680
00:27:02,319 --> 00:27:07,639
because there was no coupon at day one.

681
00:27:04,799 --> 00:27:09,799
We only had a final payment of 100. But

682
00:27:07,640 --> 00:27:11,800
we did this already when we compare the

683
00:27:09,799 --> 00:27:14,519
one-year bond with holding the two-year

684
00:27:11,799 --> 00:27:15,960
bond for one period. We had exactly that

685
00:27:14,519 --> 00:27:17,559
except that there was the expected

686
00:27:15,960 --> 00:27:20,360
dividend there was zero because there

687
00:27:17,559 --> 00:27:22,000
was no payment at the intermediate date.

688
00:27:20,359 --> 00:27:23,879
Okay?

689
00:27:22,000 --> 00:27:25,799
Good. So, we we know this concept

690
00:27:23,880 --> 00:27:27,920
already. The only difference here is

691
00:27:25,799 --> 00:27:31,119
again that there is expected dividend

692
00:27:27,920 --> 00:27:32,960
and second that we have a risk premium

693
00:27:31,119 --> 00:27:34,639
here which we added for bonds, but for

694
00:27:32,960 --> 00:27:36,880
equity as I said it's typically much

695
00:27:34,640 --> 00:27:40,759
larger than for bonds, especially if

696
00:27:36,880 --> 00:27:40,760
you're talking about treasury bonds.

697
00:27:41,559 --> 00:27:45,678
So, I'm going to reorganize this to

698
00:27:43,000 --> 00:27:46,799
solve out for the price, this QT here.

699
00:27:45,679 --> 00:27:48,600
That's what I want to figure out. What

700
00:27:46,799 --> 00:27:49,759
is the price of the share of Apple?

701
00:27:48,599 --> 00:27:50,959
Okay?

702
00:27:49,759 --> 00:27:53,200
Well

703
00:27:50,960 --> 00:27:54,600
I can reorganize this which means, you

704
00:27:53,200 --> 00:27:57,400
know, move

705
00:27:54,599 --> 00:28:00,919
dollar QT to the left, divide these two

706
00:27:57,400 --> 00:28:02,519
guys here by 1 + I1T + XS and I get

707
00:28:00,920 --> 00:28:05,440
this. Okay?

708
00:28:02,519 --> 00:28:07,319
So, the price is equal to

709
00:28:05,440 --> 00:28:09,640
the discounted

710
00:28:07,319 --> 00:28:11,079
expected dividend. I have to discount it

711
00:28:09,640 --> 00:28:13,720
because I expect to receive it one year

712
00:28:11,079 --> 00:28:15,240
from now and I want I also compensation

713
00:28:13,720 --> 00:28:19,039
for risk

714
00:28:15,240 --> 00:28:20,679
plus the discounted value of the

715
00:28:19,039 --> 00:28:23,000
money I'm going to get from from selling

716
00:28:20,679 --> 00:28:25,480
the share of Apple one year from now.

717
00:28:23,000 --> 00:28:27,400
Okay? Which I also discount

718
00:28:25,480 --> 00:28:28,919
by the interest rate, but also with a

719
00:28:27,400 --> 00:28:30,080
risk premium because that's a risky

720
00:28:28,919 --> 00:28:31,880
investment.

721
00:28:30,079 --> 00:28:34,519
Okay?

722
00:28:31,880 --> 00:28:36,400
So, that's what we have.

723
00:28:34,519 --> 00:28:39,279
Now

724
00:28:36,400 --> 00:28:39,280
notice that

725
00:28:39,799 --> 00:28:44,639
at T + 1

726
00:28:42,919 --> 00:28:46,240
I will have an expression like that as

727
00:28:44,640 --> 00:28:48,120
well.

728
00:28:46,240 --> 00:28:50,440
Okay, again.

729
00:28:48,119 --> 00:28:52,719
When we did the two-year bond

730
00:28:50,440 --> 00:28:54,159
we didn't have an expression like that

731
00:28:52,720 --> 00:28:56,240
because

732
00:28:54,159 --> 00:28:58,159
after after one year the two-year bond

733
00:28:56,240 --> 00:28:59,960
was going to be a one-year bond.

734
00:28:58,159 --> 00:29:02,880
And so, we didn't need to think of put a

735
00:28:59,960 --> 00:29:04,640
price there. We just put the 100. Okay?

736
00:29:02,880 --> 00:29:06,919
Here is different because we said this

737
00:29:04,640 --> 00:29:09,720
equity never expires unless the company

738
00:29:06,919 --> 00:29:11,960
goes bankrupt, it's there.

739
00:29:09,720 --> 00:29:14,039
So, in the next date I'm going to have

740
00:29:11,960 --> 00:29:16,679
an expression exactly like that. I'm

741
00:29:14,039 --> 00:29:19,678
just going to have an expected T +

742
00:29:16,679 --> 00:29:22,600
dividend at T + 2 and expected price at

743
00:29:19,679 --> 00:29:24,120
T + 2. Okay? And so on and so forth.

744
00:29:22,599 --> 00:29:27,079
That means

745
00:29:24,119 --> 00:29:30,000
I can replace this expression here

746
00:29:27,079 --> 00:29:32,759
by an expression like this shifted all

747
00:29:30,000 --> 00:29:32,759
by one year.

748
00:29:33,319 --> 00:29:39,359
Okay? And I keep can keep doing that.

749
00:29:36,400 --> 00:29:41,240
Then if I do that, I'm going to get then

750
00:29:39,359 --> 00:29:42,519
two expected dividends here and then I'm

751
00:29:41,240 --> 00:29:44,960
going to get a

752
00:29:42,519 --> 00:29:46,519
uh So, I'm going to get

753
00:29:44,960 --> 00:29:49,079
something like this but shifted by one

754
00:29:46,519 --> 00:29:51,079
year and discounted by two terms in the

755
00:29:49,079 --> 00:29:54,039
denominator, and then I'm going to get a

756
00:29:51,079 --> 00:29:56,000
expected Q QT + 2.

757
00:29:54,039 --> 00:29:57,639
Around here, okay?

758
00:29:56,000 --> 00:29:59,839
Well, I can do a substitution of that as

759
00:29:57,640 --> 00:30:01,680
well. Again,

760
00:29:59,839 --> 00:30:03,319
okay? By everything shifted by two

761
00:30:01,680 --> 00:30:05,160
years, and so on.

762
00:30:03,319 --> 00:30:06,720
So, I can keep going.

763
00:30:05,160 --> 00:30:08,600
And I can keep going, and going, and

764
00:30:06,720 --> 00:30:09,519
going, and going on forever.

765
00:30:08,599 --> 00:30:11,439
Okay?

766
00:30:09,519 --> 00:30:12,279
So, if you keep doing it,

767
00:30:11,440 --> 00:30:15,080
you're going to end up with an

768
00:30:12,279 --> 00:30:18,039
expression that gives you the price of

769
00:30:15,079 --> 00:30:19,720
the asset as expected this

770
00:30:18,039 --> 00:30:22,920
present discounted value of all the

771
00:30:19,720 --> 00:30:24,519
future dividends you expect.

772
00:30:22,920 --> 00:30:26,759
Okay?

773
00:30:24,519 --> 00:30:30,519
You see? I I'm summing

774
00:30:26,759 --> 00:30:31,759
the T + 2, 3, 4, 5, and doesn't stop

775
00:30:30,519 --> 00:30:34,519
here.

776
00:30:31,759 --> 00:30:36,480
If I stop here, I'm going to have here a

777
00:30:34,519 --> 00:30:38,799
you know, a Q

778
00:30:36,480 --> 00:30:40,120
E T + N

779
00:30:38,799 --> 00:30:41,559
+ 1.

780
00:30:40,119 --> 00:30:42,839
Well, I can replace that thing again,

781
00:30:41,559 --> 00:30:43,879
and I can keep going, keep going

782
00:30:42,839 --> 00:30:45,240
forever.

783
00:30:43,880 --> 00:30:48,080
Okay? So, you're going to integrate the

784
00:30:45,240 --> 00:30:50,720
expected dividends, discounted dividends

785
00:30:48,079 --> 00:30:50,720
to infinity.

786
00:30:51,160 --> 00:30:55,480
Now, each future dividend is discounted

787
00:30:53,680 --> 00:30:57,080
more and more heavily because the

788
00:30:55,480 --> 00:30:58,400
denominator is growing, and growing, and

789
00:30:57,079 --> 00:31:00,960
growing, because it's further out in the

790
00:30:58,400 --> 00:31:03,480
future, it's worth less and less. Okay?

791
00:31:00,960 --> 00:31:05,000
But, still it can go on forever.

792
00:31:03,480 --> 00:31:07,599
And in fact, even if you if you

793
00:31:05,000 --> 00:31:09,240
substitute this stuff a million times,

794
00:31:07,599 --> 00:31:12,480
there's going to still be a little price

795
00:31:09,240 --> 00:31:16,079
at the very end floating around.

796
00:31:12,480 --> 00:31:18,039
Discounted, but it will never go away.

797
00:31:16,079 --> 00:31:19,240
Okay? So, it never ends. There's no

798
00:31:18,039 --> 00:31:21,879
maturity.

799
00:31:19,240 --> 00:31:21,880
They keep going.

800
00:31:22,559 --> 00:31:28,079
Now, I did everything up to now for

801
00:31:24,640 --> 00:31:29,560
nominal in nominal terms. You can do

802
00:31:28,079 --> 00:31:30,599
And that's the reason I

803
00:31:29,559 --> 00:31:31,919
didn't want to spend much time with

804
00:31:30,599 --> 00:31:33,359
this. You can do everything in real

805
00:31:31,920 --> 00:31:34,000
terms as well.

806
00:31:33,359 --> 00:31:35,959
Uh

807
00:31:34,000 --> 00:31:37,839
and and and all all that happens here is

808
00:31:35,960 --> 00:31:41,039
just remove the dollars, and just be

809
00:31:37,839 --> 00:31:42,399
careful to replace uh

810
00:31:41,039 --> 00:31:44,399
the nominal interest rate by the real

811
00:31:42,400 --> 00:31:47,040
interest rate, but nothing deep there.

812
00:31:44,400 --> 00:31:50,560
Okay? I can you can go to real pricing,

813
00:31:47,039 --> 00:31:50,559
nominal pricing, and so on.

814
00:31:50,599 --> 00:31:55,279
Okay? But, the the important concept is

815
00:31:52,640 --> 00:31:58,200
not that. It is is the fact that

816
00:31:55,279 --> 00:32:01,480
this that the the in principle we call

817
00:31:58,200 --> 00:32:04,679
that, by the way, the fundamental value

818
00:32:01,480 --> 00:32:06,519
of a of a of a of equity or of stock is

819
00:32:04,679 --> 00:32:08,280
the expected present discounted value of

820
00:32:06,519 --> 00:32:09,799
all the dividends. And you have to

821
00:32:08,279 --> 00:32:11,839
discount it by the proper discounting

822
00:32:09,799 --> 00:32:13,240
factor, which includes interest rate and

823
00:32:11,839 --> 00:32:15,639
risk premium. But, that's what we call

824
00:32:13,240 --> 00:32:17,759
typically fundamentals. We differentiate

825
00:32:15,640 --> 00:32:18,960
that from what we call sometimes, I'm

826
00:32:17,759 --> 00:32:20,119
going to show you an example later on,

827
00:32:18,960 --> 00:32:23,000
bubbles.

828
00:32:20,119 --> 00:32:26,359
When when the price seems to exceed

829
00:32:23,000 --> 00:32:28,799
any reasonable sense of fundamentals.

830
00:32:26,359 --> 00:32:28,799
Okay?

831
00:32:32,599 --> 00:32:36,799
Okay, good.

832
00:32:34,279 --> 00:32:40,480
Okay, let me sort of start

833
00:32:36,799 --> 00:32:41,919
going back to to things that that um

834
00:32:40,480 --> 00:32:43,400
we worry about in this course, and in

835
00:32:41,920 --> 00:32:45,080
fact is a big issue. I don't know what

836
00:32:43,400 --> 00:32:47,080
is happening to markets now. The what

837
00:32:45,079 --> 00:32:48,199
the Fed did was very anticipated, but

838
00:32:47,079 --> 00:32:50,159
but

839
00:32:48,200 --> 00:32:53,240
um

840
00:32:50,160 --> 00:32:54,480
but markets of often find a way to react

841
00:32:53,240 --> 00:32:57,400
to things even if things were

842
00:32:54,480 --> 00:32:57,400
anticipated, but

843
00:32:57,519 --> 00:33:01,879
What happens? So, let me ask you a

844
00:32:59,480 --> 00:33:03,319
following question.

845
00:33:01,880 --> 00:33:05,040
What is the effect What do you think is

846
00:33:03,319 --> 00:33:08,240
the effect

847
00:33:05,039 --> 00:33:09,960
of an expansionary monetary policy

848
00:33:08,240 --> 00:33:13,120
on the asset prices we have discussed?

849
00:33:09,960 --> 00:33:15,160
So, bonds and equity.

850
00:33:13,119 --> 00:33:16,839
Let's start with bonds

851
00:33:15,160 --> 00:33:18,320
first.

852
00:33:16,839 --> 00:33:20,119
What do you think is the effect of an

853
00:33:18,319 --> 00:33:21,960
expansionary monetary policy? That means

854
00:33:20,119 --> 00:33:24,279
a reduction in the interest rate on the

855
00:33:21,960 --> 00:33:27,400
price of your 1-year bond, 2-year bond,

856
00:33:24,279 --> 00:33:27,399
any any year you pick.

857
00:33:30,119 --> 00:33:33,719
We already talked about that earlier.

858
00:33:35,440 --> 00:33:39,799
Goes up.

859
00:33:36,920 --> 00:33:41,080
The price of a bond is inversely related

860
00:33:39,799 --> 00:33:43,200
to

861
00:33:41,079 --> 00:33:44,599
the interest rate because if I cut an

862
00:33:43,200 --> 00:33:45,679
interest rate,

863
00:33:44,599 --> 00:33:47,439
means

864
00:33:45,679 --> 00:33:49,160
a bond is something that pays the payoff

865
00:33:47,440 --> 00:33:52,160
is in the future.

866
00:33:49,160 --> 00:33:54,759
That thing in the future is worth more

867
00:33:52,160 --> 00:33:56,440
if the interest rate goes down.

868
00:33:54,759 --> 00:33:58,079
There's less discounting of it.

869
00:33:56,440 --> 00:33:59,640
So, the price of the bond, any bond

870
00:33:58,079 --> 00:34:02,159
here, will go up. The 1-year, 2-year,

871
00:33:59,640 --> 00:34:04,600
3-year, 5-year, all of them.

872
00:34:02,160 --> 00:34:06,080
They'll go up. Okay?

873
00:34:04,599 --> 00:34:07,759
Assuming that nothing changes as a

874
00:34:06,079 --> 00:34:09,440
result of the monetary policy. Look,

875
00:34:07,759 --> 00:34:11,239
what happens is sometimes,

876
00:34:09,440 --> 00:34:13,119
you know, markets think, "Oops, the Fed

877
00:34:11,239 --> 00:34:14,878
messed up." And that leads to lots of

878
00:34:13,119 --> 00:34:16,639
changes in all the term structure and

879
00:34:14,878 --> 00:34:18,319
things like that because

880
00:34:16,639 --> 00:34:20,639
they expect the market to react in a

881
00:34:18,320 --> 00:34:22,480
strange ways to to this mistake made by

882
00:34:20,639 --> 00:34:24,199
the Fed. But, here I'm saying suppose

883
00:34:22,480 --> 00:34:25,760
that the Fed just cuts the interest rate

884
00:34:24,199 --> 00:34:27,839
once, and everyone believes that the Fed

885
00:34:25,760 --> 00:34:31,159
will continue to do so, and so on.

886
00:34:27,840 --> 00:34:34,039
Well, then you're going to get uh that

887
00:34:31,159 --> 00:34:37,679
that the price of bonds will go up.

888
00:34:34,039 --> 00:34:37,679
What will happen to the price of stocks?

889
00:34:38,079 --> 00:34:40,918
You want to answer.

890
00:34:41,079 --> 00:34:45,079
Up.

891
00:34:43,039 --> 00:34:46,519
But, it's

892
00:34:45,079 --> 00:34:49,279
Well, but it's important to see that it

893
00:34:46,519 --> 00:34:50,878
will go up probably for two reasons.

894
00:34:49,280 --> 00:34:52,840
The first one

895
00:34:50,878 --> 00:34:54,239
is that that

896
00:34:52,840 --> 00:34:55,879
um

897
00:34:54,239 --> 00:34:58,039
is that

898
00:34:55,878 --> 00:35:00,159
it's also the case that a lot of the

899
00:34:58,039 --> 00:35:01,480
price of an equity, actually even more

900
00:35:00,159 --> 00:35:04,239
so than a bond,

901
00:35:01,480 --> 00:35:05,358
has to do with expected payoffs in the

902
00:35:04,239 --> 00:35:06,559
future.

903
00:35:05,358 --> 00:35:09,480
So, if I lower interest rate, just the

904
00:35:06,559 --> 00:35:11,719
effect of discounting will tend to raise

905
00:35:09,480 --> 00:35:13,800
the price of So, even if I don't change

906
00:35:11,719 --> 00:35:14,919
the expected dividends at all,

907
00:35:13,800 --> 00:35:15,920
the fact that the interest rate goes

908
00:35:14,920 --> 00:35:17,280
down,

909
00:35:15,920 --> 00:35:19,079
for the same reason that the price of a

910
00:35:17,280 --> 00:35:21,519
bond went up, the price of equity will

911
00:35:19,079 --> 00:35:23,519
tend to go up. Okay? So, that's exactly

912
00:35:21,519 --> 00:35:25,119
is the same logic.

913
00:35:23,519 --> 00:35:27,400
But, there's an extra kick here for

914
00:35:25,119 --> 00:35:29,159
equity, which is what?

915
00:35:27,400 --> 00:35:31,358
That bonds did not have,

916
00:35:29,159 --> 00:35:33,639
but equity does.

917
00:35:31,358 --> 00:35:35,239
At least if it is an equity that is

918
00:35:33,639 --> 00:35:36,519
positively related to aggregate

919
00:35:35,239 --> 00:35:38,799
activity, but that's what I'm assuming

920
00:35:36,519 --> 00:35:38,800
here.

921
00:35:53,800 --> 00:35:57,120
Well,

922
00:35:55,039 --> 00:35:59,079
yeah, that's the logic, no? Here, the

923
00:35:57,119 --> 00:36:00,519
expansionary monetary policy is cutting

924
00:35:59,079 --> 00:36:02,279
interest rate, but as a result of that,

925
00:36:00,519 --> 00:36:04,358
output is going up.

926
00:36:02,280 --> 00:36:06,359
When output is going up, sales will go

927
00:36:04,358 --> 00:36:08,159
up, revenues will go up, dividends will

928
00:36:06,358 --> 00:36:10,559
probably go up as well.

929
00:36:08,159 --> 00:36:12,599
So, monetary policy can have very large

930
00:36:10,559 --> 00:36:13,840
effect. I mean,

931
00:36:12,599 --> 00:36:15,679
people in financial markets are looking

932
00:36:13,840 --> 00:36:18,600
at the Fed all the time because it can

933
00:36:15,679 --> 00:36:19,759
have a big impact on the price of those

934
00:36:18,599 --> 00:36:21,759
assets.

935
00:36:19,760 --> 00:36:23,280
An equity in particular can can be very

936
00:36:21,760 --> 00:36:25,880
strong. And in fact, that's one of the

937
00:36:23,280 --> 00:36:28,680
ways monetary policy works.

938
00:36:25,880 --> 00:36:31,079
You know, when when when

939
00:36:28,679 --> 00:36:32,919
the Fed cuts interest rates,

940
00:36:31,079 --> 00:36:35,079
inflate it inflates the value of asset

941
00:36:32,920 --> 00:36:37,320
prices, and that creates more wealth,

942
00:36:35,079 --> 00:36:40,159
people feel richer, consume more, blah

943
00:36:37,320 --> 00:36:42,200
blah blah. Firms feel also richer, they

944
00:36:40,159 --> 00:36:43,000
invest more, and so on. That's That's it

945
00:36:42,199 --> 00:36:45,639
That's

946
00:36:43,000 --> 00:36:47,480
That's deliberate in a sense. Okay?

947
00:36:45,639 --> 00:36:49,719
Uh that's one of the main mechanisms

948
00:36:47,480 --> 00:36:52,719
through which monetary policy affects

949
00:36:49,719 --> 00:36:54,399
aggregate demand. Just creates wealth.

950
00:36:52,719 --> 00:36:56,239
And when there's too much demand too

951
00:36:54,400 --> 00:36:57,639
much aggregate demand, like last like is

952
00:36:56,239 --> 00:36:59,239
going on now, that's the reason we have

953
00:36:57,639 --> 00:37:02,480
inflation, and so on.

954
00:36:59,239 --> 00:37:05,079
You know, in 2022, the Fed went out and

955
00:37:02,480 --> 00:37:06,679
deliberately destroyed wealth.

956
00:37:05,079 --> 00:37:08,719
Because that's what that's what needed

957
00:37:06,679 --> 00:37:10,719
to. Raise interest rate a lot, the price

958
00:37:08,719 --> 00:37:13,639
of equity came down, even houses began

959
00:37:10,719 --> 00:37:16,000
to bubble. Okay? The price of

960
00:37:13,639 --> 00:37:19,079
uh of of treasury bonds also collapsed,

961
00:37:16,000 --> 00:37:21,159
and so on and so forth. Okay?

962
00:37:19,079 --> 00:37:22,840
Good.

963
00:37:21,159 --> 00:37:25,079
Another experiment that we did sort of

964
00:37:22,840 --> 00:37:26,358
early on, lecture three, four, but

965
00:37:25,079 --> 00:37:27,840
around there,

966
00:37:26,358 --> 00:37:29,559
is

967
00:37:27,840 --> 00:37:30,800
What happens What do you think happens

968
00:37:29,559 --> 00:37:32,279
when there's an increase in consumer

969
00:37:30,800 --> 00:37:34,280
spending?

970
00:37:32,280 --> 00:37:36,680
So, suppose that now, remember we had a

971
00:37:34,280 --> 00:37:39,800
a C 0 floating around, an autonomous

972
00:37:36,679 --> 00:37:42,759
consumption component, and so suppose

973
00:37:39,800 --> 00:37:42,760
that that goes up.

974
00:37:43,480 --> 00:37:47,000
What do you think happens to asset

975
00:37:44,519 --> 00:37:47,000
prices?

976
00:37:47,358 --> 00:37:51,199
And this is a big issue these days,

977
00:37:48,679 --> 00:37:51,199
actually.

978
00:37:54,079 --> 00:37:58,400
Exactly. That's right. That's That's

979
00:37:56,599 --> 00:38:00,119
That's very good. It depends a lot. I

980
00:37:58,400 --> 00:38:02,039
mean, when financial markets receive

981
00:38:00,119 --> 00:38:05,000
news every day, there are releases of

982
00:38:02,039 --> 00:38:06,320
news and of all sort of things. Okay?

983
00:38:05,000 --> 00:38:08,358
And and

984
00:38:06,320 --> 00:38:10,920
in financial markets, they people always

985
00:38:08,358 --> 00:38:13,159
think, "Okay, this is the news.

986
00:38:10,920 --> 00:38:14,519
The obvious thing for this is

987
00:38:13,159 --> 00:38:16,358
you know, good news, because this will

988
00:38:14,519 --> 00:38:17,880
tend to increase output. Output will

989
00:38:16,358 --> 00:38:19,079
increase dividends. That's a good good

990
00:38:17,880 --> 00:38:20,440
thing for

991
00:38:19,079 --> 00:38:21,880
for stocks."

992
00:38:20,440 --> 00:38:24,559
Uh

993
00:38:21,880 --> 00:38:26,200
But, the immediate reaction is, "Whoa,

994
00:38:24,559 --> 00:38:27,920
but what will the Fed do about this?

995
00:38:26,199 --> 00:38:29,480
Does the Fed like

996
00:38:27,920 --> 00:38:30,720
that we have more aggregate demand or

997
00:38:29,480 --> 00:38:31,800
not?"

998
00:38:30,719 --> 00:38:34,358
Okay?

999
00:38:31,800 --> 00:38:35,680
And so so so that's that's

1000
00:38:34,358 --> 00:38:39,400
key here.

1001
00:38:35,679 --> 00:38:41,399
And and uh so suppose that in this case,

1002
00:38:39,400 --> 00:38:43,680
the Fed did not like

1003
00:38:41,400 --> 00:38:45,639
the Fed like today to the Fed doesn't

1004
00:38:43,679 --> 00:38:46,879
want more aggregate demand today.

1005
00:38:45,639 --> 00:38:48,799
There's no central bank around the

1006
00:38:46,880 --> 00:38:50,599
world, maybe in China, but but there's

1007
00:38:48,800 --> 00:38:53,080
no other central bank around the world

1008
00:38:50,599 --> 00:38:54,440
that wants more aggregate demand.

1009
00:38:53,079 --> 00:38:57,759
Okay?

1010
00:38:54,440 --> 00:39:00,280
So, so if if it's if if you the release

1011
00:38:57,760 --> 00:39:02,359
is consumer

1012
00:39:00,280 --> 00:39:03,440
are very bullish now,

1013
00:39:02,358 --> 00:39:06,199
uh

1014
00:39:03,440 --> 00:39:08,280
that's not good news. I mean, financial

1015
00:39:06,199 --> 00:39:10,319
markets immediately say, "Uh-oh, we have

1016
00:39:08,280 --> 00:39:11,240
a Fed that is watching for inflation.

1017
00:39:10,320 --> 00:39:12,519
This means they're going to hike

1018
00:39:11,239 --> 00:39:13,679
interest rates."

1019
00:39:12,519 --> 00:39:15,840
Okay?

1020
00:39:13,679 --> 00:39:19,480
So, what happens to the price of bonds

1021
00:39:15,840 --> 00:39:21,280
then in this environment when C 0 goes

1022
00:39:19,480 --> 00:39:22,760
up, and the Fed doesn't like it? And and

1023
00:39:21,280 --> 00:39:24,880
the markets know that the Fed doesn't

1024
00:39:22,760 --> 00:39:26,600
like it. The Fed may take a month to

1025
00:39:24,880 --> 00:39:28,240
react to it, but markets react

1026
00:39:26,599 --> 00:39:30,679
immediately, say, "Whoa, this is what

1027
00:39:28,239 --> 00:39:32,159
the Fed will do 1 month from now."

1028
00:39:30,679 --> 00:39:33,399
Okay?

1029
00:39:32,159 --> 00:39:35,239
So, what do you think happens to the

1030
00:39:33,400 --> 00:39:37,079
price of bonds

1031
00:39:35,239 --> 00:39:38,599
if we get news that, you know, consumers

1032
00:39:37,079 --> 00:39:41,119
are

1033
00:39:38,599 --> 00:39:42,400
very bullish, and and and and it turns

1034
00:39:41,119 --> 00:39:45,000
out that we also have

1035
00:39:42,400 --> 00:39:46,480
of you know 4% or so, so we know that

1036
00:39:45,000 --> 00:39:48,480
the Fed doesn't like more aggregate

1037
00:39:46,480 --> 00:39:49,519
demand.

1038
00:39:48,480 --> 00:39:52,400
What do you think will happen to the

1039
00:39:49,519 --> 00:39:52,400
price of bonds?

1040
00:39:56,599 --> 00:39:59,960
Well,

1041
00:39:58,480 --> 00:40:02,240
again,

1042
00:39:59,960 --> 00:40:03,880
the news happens say

1043
00:40:02,239 --> 00:40:05,399
uh

1044
00:40:03,880 --> 00:40:07,680
a week ago

1045
00:40:05,400 --> 00:40:10,280
and the Fed moves one week later.

1046
00:40:07,679 --> 00:40:11,599
So so markets are going to anticipate

1047
00:40:10,280 --> 00:40:14,000
that in this case the Fed will hike

1048
00:40:11,599 --> 00:40:15,839
interest rates.

1049
00:40:14,000 --> 00:40:17,320
If the Fed is the markets anticipate

1050
00:40:15,840 --> 00:40:19,640
that the Fed will hike interest rate,

1051
00:40:17,320 --> 00:40:21,320
interest rate will go up immediately.

1052
00:40:19,639 --> 00:40:22,719
Not the not the rate that the Fed

1053
00:40:21,320 --> 00:40:24,160
controls, but the one-year rate, the

1054
00:40:22,719 --> 00:40:25,799
two-year rate, the three-month rate, all

1055
00:40:24,159 --> 00:40:28,319
those rates are going to go up

1056
00:40:25,800 --> 00:40:30,519
immediately as a result of that.

1057
00:40:28,320 --> 00:40:31,680
Okay? And that

1058
00:40:30,519 --> 00:40:33,559
we know

1059
00:40:31,679 --> 00:40:35,359
reduces the price of bonds. Bonds and

1060
00:40:33,559 --> 00:40:36,440
interest rates are The price of a bond

1061
00:40:35,360 --> 00:40:38,720
and the interest rates are inversely

1062
00:40:36,440 --> 00:40:41,200
related. So the anticipation that the

1063
00:40:38,719 --> 00:40:43,759
Fed will hike rate will lead to higher

1064
00:40:41,199 --> 00:40:46,319
interest rates at all horizons and and

1065
00:40:43,760 --> 00:40:50,680
and that will reduce the price of bonds.

1066
00:40:46,320 --> 00:40:52,039
Okay? So this thing that and for equity,

1067
00:40:50,679 --> 00:40:54,399
well, look what happened for equity

1068
00:40:52,039 --> 00:40:56,159
here. Well, for equity you say, "Okay,

1069
00:40:54,400 --> 00:40:58,000
well, I get the same discounting effect

1070
00:40:56,159 --> 00:40:59,199
of the bond, which is bad news, goes

1071
00:40:58,000 --> 00:41:00,480
down."

1072
00:40:59,199 --> 00:41:01,960
And

1073
00:41:00,480 --> 00:41:03,639
and what about The good news is the

1074
00:41:01,960 --> 00:41:05,000
dividend, no? Because now I have more

1075
00:41:03,639 --> 00:41:07,319
consumers.

1076
00:41:05,000 --> 00:41:09,320
Well, that depends on how much the Fed

1077
00:41:07,320 --> 00:41:11,960
dislikes this stuff because if the Fed

1078
00:41:09,320 --> 00:41:13,440
does this, that mean it offsets it fully

1079
00:41:11,960 --> 00:41:16,199
offsets

1080
00:41:13,440 --> 00:41:17,960
the the effect on aggregate demand.

1081
00:41:16,199 --> 00:41:19,719
Increasing this zero shift IS to the

1082
00:41:17,960 --> 00:41:21,519
right, that would have increased output

1083
00:41:19,719 --> 00:41:23,159
to here. The Fed doesn't want more

1084
00:41:21,519 --> 00:41:24,639
output, so we will hike interest rate up

1085
00:41:23,159 --> 00:41:25,519
to the point in which output doesn't go

1086
00:41:24,639 --> 00:41:27,119
up.

1087
00:41:25,519 --> 00:41:28,880
That means dividends are not going to go

1088
00:41:27,119 --> 00:41:30,759
up either.

1089
00:41:28,880 --> 00:41:33,320
So we get just a negative effect of the

1090
00:41:30,760 --> 00:41:34,640
discounting and we don't get the benefit

1091
00:41:33,320 --> 00:41:36,600
of the extra activity that would have

1092
00:41:34,639 --> 00:41:39,799
come from having consumers that are more

1093
00:41:36,599 --> 00:41:41,559
optimistic and so on. Okay?

1094
00:41:39,800 --> 00:41:42,840
So this is actually this has happened a

1095
00:41:41,559 --> 00:41:43,400
lot

1096
00:41:42,840 --> 00:41:45,400
uh

1097
00:41:43,400 --> 00:41:47,680
over the last few months.

1098
00:41:45,400 --> 00:41:49,280
This is an environment people call it's

1099
00:41:47,679 --> 00:41:50,559
an environment where good news is bad

1100
00:41:49,280 --> 00:41:51,480
news.

1101
00:41:50,559 --> 00:41:52,960
Okay?

1102
00:41:51,480 --> 00:41:54,760
Good news about aggregate demand,

1103
00:41:52,960 --> 00:41:56,599
consumers are happy, blah blah blah, is

1104
00:41:54,760 --> 00:41:58,800
bad news or labor markets are very

1105
00:41:56,599 --> 00:42:00,360
tight, wages are going up.

1106
00:41:58,800 --> 00:42:01,680
All things that sound wonderful in other

1107
00:42:00,360 --> 00:42:03,720
environments

1108
00:42:01,679 --> 00:42:06,719
sound terrible news for the financial

1109
00:42:03,719 --> 00:42:06,719
markets. Okay?

1110
00:42:06,960 --> 00:42:10,360
For most, I mean there's difference in

1111
00:42:08,559 --> 00:42:12,480
different sectors and so on, but but for

1112
00:42:10,360 --> 00:42:14,079
the aggregate, for the average,

1113
00:42:12,480 --> 00:42:16,639
it's bad news. So this is an environment

1114
00:42:14,079 --> 00:42:17,759
where good news is bad news. Good news

1115
00:42:16,639 --> 00:42:19,279
about aggregate demand, you have to be

1116
00:42:17,760 --> 00:42:21,200
specific about what. Good news about

1117
00:42:19,280 --> 00:42:23,040
aggregate demand is bad news

1118
00:42:21,199 --> 00:42:24,960
for asset markets.

1119
00:42:23,039 --> 00:42:27,480
It's not always like that.

1120
00:42:24,960 --> 00:42:28,920
If you're in a recession,

1121
00:42:27,480 --> 00:42:30,400
the Fed doesn't want to fight that. It

1122
00:42:28,920 --> 00:42:31,800
wants to have more aggregate demand. So

1123
00:42:30,400 --> 00:42:33,280
if you get good news about aggregate

1124
00:42:31,800 --> 00:42:34,400
demand, that's very good news for asset

1125
00:42:33,280 --> 00:42:36,680
prices

1126
00:42:34,400 --> 00:42:38,400
because the Fed will not offset that and

1127
00:42:36,679 --> 00:42:41,239
you get the positive effect of the extra

1128
00:42:38,400 --> 00:42:43,800
dividends and things like that. Okay?

1129
00:42:41,239 --> 00:42:43,799
So

1130
00:42:43,880 --> 00:42:47,960
Okay.

1131
00:42:45,639 --> 00:42:49,920
Another component that is that moves

1132
00:42:47,960 --> 00:42:52,880
asset prices a lot. So monetary policy

1133
00:42:49,920 --> 00:42:54,320
moves asset prices a lot. Okay? And and

1134
00:42:52,880 --> 00:42:55,559
monetary but monetary policy doesn't

1135
00:42:54,320 --> 00:42:58,760
happen in

1136
00:42:55,559 --> 00:43:00,759
some separate isolated space. It it it

1137
00:42:58,760 --> 00:43:03,880
reacts to news about the economy, about

1138
00:43:00,760 --> 00:43:07,440
consumers, about firms, about regional

1139
00:43:03,880 --> 00:43:11,920
banks, all sort of things. Okay?

1140
00:43:07,440 --> 00:43:13,360
Uh another big driver of asset prices is

1141
00:43:11,920 --> 00:43:15,880
this guy here

1142
00:43:13,360 --> 00:43:17,519
of of equity in particular

1143
00:43:15,880 --> 00:43:18,720
is this risk premium.

1144
00:43:17,519 --> 00:43:21,920
Okay?

1145
00:43:18,719 --> 00:43:23,679
So that risk premium can move a lot

1146
00:43:21,920 --> 00:43:25,920
and and it's an important driver of

1147
00:43:23,679 --> 00:43:28,559
asset prices.

1148
00:43:25,920 --> 00:43:30,880
This index, this is the it's called VIX.

1149
00:43:28,559 --> 00:43:32,119
VIX is I'm not going to explain what it

1150
00:43:30,880 --> 00:43:34,280
is, but

1151
00:43:32,119 --> 00:43:37,239
people call it so you get a the picture,

1152
00:43:34,280 --> 00:43:38,920
an index of fear in an equity market. It

1153
00:43:37,239 --> 00:43:39,919
it it's it's done

1154
00:43:38,920 --> 00:43:42,000
Well, I'm not going to tell you what it

1155
00:43:39,920 --> 00:43:43,320
is. It's it's based on option prices and

1156
00:43:42,000 --> 00:43:45,360
so on.

1157
00:43:43,320 --> 00:43:47,160
Uh so this is

1158
00:43:45,360 --> 00:43:48,800
this is, you know, when people realize

1159
00:43:47,159 --> 00:43:51,480
that COVID

1160
00:43:48,800 --> 00:43:54,080
was coming and so what you see is that

1161
00:43:51,480 --> 00:43:56,320
this thing exploded up.

1162
00:43:54,079 --> 00:43:58,159
Big big risk off.

1163
00:43:56,320 --> 00:44:00,160
That's a massive spike in the little

1164
00:43:58,159 --> 00:44:01,639
excess.

1165
00:44:00,159 --> 00:44:03,279
Well, not surprisingly look what

1166
00:44:01,639 --> 00:44:06,039
happened to equity.

1167
00:44:03,280 --> 00:44:07,840
You know, collapsed by 35% or so.

1168
00:44:06,039 --> 00:44:09,320
Part of that was expected dividends,

1169
00:44:07,840 --> 00:44:11,800
blah blah blah,

1170
00:44:09,320 --> 00:44:14,440
but a lot of it was the risk off.

1171
00:44:11,800 --> 00:44:16,480
And it's called risk off when

1172
00:44:14,440 --> 00:44:20,320
markets are very fearful. They don't

1173
00:44:16,480 --> 00:44:22,760
want to take risks, risk off. Okay? Uh

1174
00:44:20,320 --> 00:44:24,120
the recovery actually also had a lot to

1175
00:44:22,760 --> 00:44:26,560
do with

1176
00:44:24,119 --> 00:44:27,880
the recovery on the risk environment.

1177
00:44:26,559 --> 00:44:29,440
People were sort of

1178
00:44:27,880 --> 00:44:31,440
getting used to the thing.

1179
00:44:29,440 --> 00:44:33,720
But that recovery also was a result of

1180
00:44:31,440 --> 00:44:35,800
very aggressive monetary policy. The Fed

1181
00:44:33,719 --> 00:44:38,319
tried to offset this by it cutting

1182
00:44:35,800 --> 00:44:40,400
interest rates very aggressively and

1183
00:44:38,320 --> 00:44:42,120
that also gave a boost to asset prices.

1184
00:44:40,400 --> 00:44:43,519
In fact, they did so much that we ended

1185
00:44:42,119 --> 00:44:46,159
up with a big

1186
00:44:43,519 --> 00:44:47,199
lots of overvaluation in asset prices

1187
00:44:46,159 --> 00:44:49,440
and then that's the reason when they

1188
00:44:47,199 --> 00:44:50,879
hiked rates, so we had big a big decline

1189
00:44:49,440 --> 00:44:53,760
in asset prices

1190
00:44:50,880 --> 00:44:53,760
as a result. Okay?

1191
00:44:54,280 --> 00:44:58,160
What is this? Ah, look, this is

1192
00:44:57,079 --> 00:45:00,199
you know

1193
00:44:58,159 --> 00:45:02,440
over the weekend

1194
00:45:00,199 --> 00:45:03,519
over the weekend the

1195
00:45:02,440 --> 00:45:04,800
I I

1196
00:45:03,519 --> 00:45:06,920
we talked about this in the previous

1197
00:45:04,800 --> 00:45:09,720
lecture

1198
00:45:06,920 --> 00:45:11,159
um essentially the First Republic Bank

1199
00:45:09,719 --> 00:45:14,839
went under

1200
00:45:11,159 --> 00:45:18,399
uh and JP Morgan absorbed it.

1201
00:45:14,840 --> 00:45:20,800
Uh so people thought that um

1202
00:45:18,400 --> 00:45:22,639
that on Monday was was good because you

1203
00:45:20,800 --> 00:45:26,160
know, people thought that

1204
00:45:22,639 --> 00:45:28,719
this mini crisis was over.

1205
00:45:26,159 --> 00:45:31,759
Well, yesterday

1206
00:45:28,719 --> 00:45:33,919
uh it turns out that that

1207
00:45:31,760 --> 00:45:36,120
two other regional banks, their shares

1208
00:45:33,920 --> 00:45:38,480
began to collapse in the same way as the

1209
00:45:36,119 --> 00:45:41,799
First Republic Bank shares

1210
00:45:38,480 --> 00:45:43,800
collapsed the week before. Okay? So

1211
00:45:41,800 --> 00:45:45,760
panic immediately set in. So the VIX,

1212
00:45:43,800 --> 00:45:49,000
the fear index

1213
00:45:45,760 --> 00:45:51,480
This is intraday. So markets open here

1214
00:45:49,000 --> 00:45:54,639
and and the shares of this this this two

1215
00:45:51,480 --> 00:45:56,280
banks began to decline very rapidly

1216
00:45:54,639 --> 00:45:58,319
and so

1217
00:45:56,280 --> 00:46:00,400
VIX went up a lot.

1218
00:45:58,320 --> 00:46:04,080
And what you do This is SP This is the

1219
00:46:00,400 --> 00:46:07,440
main This is the SPX, the the main SP

1220
00:46:04,079 --> 00:46:09,400
S&P 500. It's the main price index

1221
00:46:07,440 --> 00:46:11,400
equity price index in the US

1222
00:46:09,400 --> 00:46:13,358
immediately declined.

1223
00:46:11,400 --> 00:46:14,440
Okay? So it's a That's the excess

1224
00:46:13,358 --> 00:46:16,480
moving.

1225
00:46:14,440 --> 00:46:18,000
Here excess move up

1226
00:46:16,480 --> 00:46:20,039
little X

1227
00:46:18,000 --> 00:46:21,840
and then it began to come down and the

1228
00:46:20,039 --> 00:46:25,000
markets began to recover.

1229
00:46:21,840 --> 00:46:26,600
So this risk on and off is a is a very

1230
00:46:25,000 --> 00:46:29,679
big driver

1231
00:46:26,599 --> 00:46:29,679
of equity prices.

1232
00:46:32,039 --> 00:46:36,400
This is one of the banks actually

1233
00:46:34,159 --> 00:46:37,679
that was in trouble.

1234
00:46:36,400 --> 00:46:39,639
Uh

1235
00:46:37,679 --> 00:46:42,399
You you see that

1236
00:46:39,639 --> 00:46:44,440
but by the end of the day this this this

1237
00:46:42,400 --> 00:46:48,079
this is

1238
00:46:44,440 --> 00:46:49,639
PacWest. PacWest had the decline by 28%

1239
00:46:48,079 --> 00:46:51,279
by the end of the day. But you see

1240
00:46:49,639 --> 00:46:53,440
things look very weird here. They don't

1241
00:46:51,280 --> 00:46:55,600
look like normal prices.

1242
00:46:53,440 --> 00:46:57,480
Okay? Here they look like normal prices.

1243
00:46:55,599 --> 00:46:59,039
They're moving all the time.

1244
00:46:57,480 --> 00:47:00,358
Here they don't.

1245
00:46:59,039 --> 00:47:02,119
What happens is that these prices

1246
00:47:00,358 --> 00:47:04,480
decline so rapidly that they they

1247
00:47:02,119 --> 00:47:06,000
trigger what is called circuit breakers.

1248
00:47:04,480 --> 00:47:08,159
So the

1249
00:47:06,000 --> 00:47:09,920
you cannot trade those those shares when

1250
00:47:08,159 --> 00:47:12,358
they decline too rapidly. And that's

1251
00:47:09,920 --> 00:47:14,440
done deliberately so this little X

1252
00:47:12,358 --> 00:47:17,159
doesn't get completely out of control.

1253
00:47:14,440 --> 00:47:19,639
People to calm down. Okay?

1254
00:47:17,159 --> 00:47:21,199
And so it triggered several times.

1255
00:47:19,639 --> 00:47:23,079
Just as

1256
00:47:21,199 --> 00:47:25,439
the the whole idea is that people calm

1257
00:47:23,079 --> 00:47:25,440
down.

1258
00:47:26,199 --> 00:47:29,559
Is there a question? Yeah, there's some

1259
00:47:28,000 --> 00:47:30,920
of us like

1260
00:47:29,559 --> 00:47:32,440
The previous or this one? Yeah, the

1261
00:47:30,920 --> 00:47:33,519
previous one.

1262
00:47:32,440 --> 00:47:35,599
Is

1263
00:47:33,519 --> 00:47:37,480
Are either of them dependent on the

1264
00:47:35,599 --> 00:47:40,440
other or are they more just showing the

1265
00:47:37,480 --> 00:47:43,199
same sort of trend? No, no. Okay, it it

1266
00:47:40,440 --> 00:47:46,599
doesn't a good question. Uh uh

1267
00:47:43,199 --> 00:47:49,279
This is the risk component only. So this

1268
00:47:46,599 --> 00:47:50,839
is more independent what I'm saying.

1269
00:47:49,280 --> 00:47:51,920
When this guy goes up, if nothing else

1270
00:47:50,840 --> 00:47:53,720
happens,

1271
00:47:51,920 --> 00:47:55,680
uh this will decline because you're

1272
00:47:53,719 --> 00:47:57,159
discounting things more heavily.

1273
00:47:55,679 --> 00:47:58,519
But it is true that there were some

1274
00:47:57,159 --> 00:48:00,559
common elements. Like there there are

1275
00:47:58,519 --> 00:48:02,440
also common elements, which is people

1276
00:48:00,559 --> 00:48:04,920
got very worried about having another

1277
00:48:02,440 --> 00:48:07,559
regional bank collapsing and so on. And

1278
00:48:04,920 --> 00:48:09,720
so that that also created fear about the

1279
00:48:07,559 --> 00:48:11,519
economy, which is an independent reason

1280
00:48:09,719 --> 00:48:14,159
for this to decline. And normally in

1281
00:48:11,519 --> 00:48:17,119
recessions as well, this risk in

1282
00:48:14,159 --> 00:48:19,559
appetite is is is is lower. So so you're

1283
00:48:17,119 --> 00:48:21,880
right that it's a common component. But

1284
00:48:19,559 --> 00:48:23,679
the point I was highlighting is that

1285
00:48:21,880 --> 00:48:26,160
is that this VIX sort of is a big

1286
00:48:23,679 --> 00:48:28,440
driver. It has a big impact on asset

1287
00:48:26,159 --> 00:48:29,960
prices.

1288
00:48:28,440 --> 00:48:32,720
But it's not the cause.

1289
00:48:29,960 --> 00:48:34,400
It was an event that caused both, but

1290
00:48:32,719 --> 00:48:37,358
the fact that this event came with this

1291
00:48:34,400 --> 00:48:39,920
biggest spike in in the VIX meant that

1292
00:48:37,358 --> 00:48:41,840
that the impact on the equity index was

1293
00:48:39,920 --> 00:48:43,760
was larger than if it had been only news

1294
00:48:41,840 --> 00:48:45,079
about the economy, meaning that there

1295
00:48:43,760 --> 00:48:46,520
was a recession ahead or something like

1296
00:48:45,079 --> 00:48:48,759
that.

1297
00:48:46,519 --> 00:48:51,480
And let me just finish with a with with

1298
00:48:48,760 --> 00:48:52,600
the opposite phenomenon.

1299
00:48:51,480 --> 00:48:54,559
You know,

1300
00:48:52,599 --> 00:48:56,839
I was talking in episodes of fear, but

1301
00:48:54,559 --> 00:48:58,920
sometimes markets get very carried away

1302
00:48:56,840 --> 00:49:01,519
in the opposite direction. Okay? And

1303
00:48:58,920 --> 00:49:03,159
here I'm showing you you know, examples.

1304
00:49:01,519 --> 00:49:05,079
I put together this picture many years

1305
00:49:03,159 --> 00:49:08,279
back and now Deutsche Bank keeps

1306
00:49:05,079 --> 00:49:10,119
updating it, which is it shows you some

1307
00:49:08,280 --> 00:49:11,840
some It seems that the world needs a

1308
00:49:10,119 --> 00:49:13,319
bubble somewhere.

1309
00:49:11,840 --> 00:49:16,720
And then here it shows you several sort

1310
00:49:13,320 --> 00:49:18,280
of big asset valuations, you know, look

1311
00:49:16,719 --> 00:49:20,159
500%.

1312
00:49:18,280 --> 00:49:22,040
This here is the Nikkei. I mean, it was

1313
00:49:20,159 --> 00:49:24,440
enormous appreciation of the Nikkei.

1314
00:49:22,039 --> 00:49:26,279
Here was Bitcoin. Then it collapsed.

1315
00:49:24,440 --> 00:49:28,039
Okay? They always end up bad. When you

1316
00:49:26,280 --> 00:49:31,480
never you see this big sort of a spiking

1317
00:49:28,039 --> 00:49:34,440
up, they almost always end up quite

1318
00:49:31,480 --> 00:49:36,240
poorly. Now, this is

1319
00:49:34,440 --> 00:49:37,880
is much more likely that it happens in

1320
00:49:36,239 --> 00:49:38,879
equity than in bonds. In bonds, it

1321
00:49:37,880 --> 00:49:40,320
cannot happen because there is a

1322
00:49:38,880 --> 00:49:43,000
terminal date,

1323
00:49:40,320 --> 00:49:44,440
a terminal value. So, so what happens

1324
00:49:43,000 --> 00:49:47,079
with these kind of things, people dream

1325
00:49:44,440 --> 00:49:48,519
that the value go will go to infinity.

1326
00:49:47,079 --> 00:49:50,199
No, and it could because the thing will

1327
00:49:48,519 --> 00:49:51,759
last to infinity and and you know, the

1328
00:49:50,199 --> 00:49:52,799
price could go to infinity. For a bond,

1329
00:49:51,760 --> 00:49:54,320
that cannot happen because it has a

1330
00:49:52,800 --> 00:49:55,519
terminal date and at that date they're

1331
00:49:54,320 --> 00:49:56,480
going to pay you 100, so it can't

1332
00:49:55,519 --> 00:49:59,119
happen.

1333
00:49:56,480 --> 00:50:01,559
But for equity, people's imagination can

1334
00:49:59,119 --> 00:50:04,239
run very wild. In fact, there is a

1335
00:50:01,559 --> 00:50:06,320
famous bubble, the South Sea Bubble.

1336
00:50:04,239 --> 00:50:08,439
It's a company in the UK.

1337
00:50:06,320 --> 00:50:10,960
It is a famous for many reasons, but but

1338
00:50:08,440 --> 00:50:13,400
one of them is that Isaac Newton got

1339
00:50:10,960 --> 00:50:14,400
involved in in this one. And and you

1340
00:50:13,400 --> 00:50:16,680
know,

1341
00:50:14,400 --> 00:50:18,480
he got carried away. He he sold, he made

1342
00:50:16,679 --> 00:50:21,639
a profit, you know, he sold the shares

1343
00:50:18,480 --> 00:50:22,880
at 7,000. He profited 3,500 pounds,

1344
00:50:21,639 --> 00:50:24,519
which must have been an enormous amount

1345
00:50:22,880 --> 00:50:26,680
of money at the time.

1346
00:50:24,519 --> 00:50:29,159
Prices kept going up,

1347
00:50:26,679 --> 00:50:31,440
couldn't resist, went back in, ended up

1348
00:50:29,159 --> 00:50:33,399
losing 20,000 pounds, which must have

1349
00:50:31,440 --> 00:50:34,960
been a lot of money. So, he famously

1350
00:50:33,400 --> 00:50:36,920
said, "I can calculate the motions of

1351
00:50:34,960 --> 00:50:38,920
the heavenly bodies, but not the madness

1352
00:50:36,920 --> 00:50:39,840
of people." It's all about expectations,

1353
00:50:38,920 --> 00:50:42,480
okay?

1354
00:50:39,840 --> 00:50:42,480
Let me stop here.