WEBVTT

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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

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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

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value today. Okay? Present discounted,

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those are the discount factors, one over

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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

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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

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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.

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Okay? Which is

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uh two instruments

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uh

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um

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should give you sort of the same

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interest rate. We're leaving risk

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considerations aside. It should give you

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the same return

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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."

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Okay?

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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

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invested in a one-year bond,

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okay? Should be equal to the return you

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get

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by investing in a in a two-year bond and

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selling that bond after one year.

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And that's the expression we had here.

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Okay?

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If you this is what you pay for a for a

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for a two-year bond, and this is what

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you expect uh uh

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to to be paid for that bond when you

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sell it one year from now. Notice that

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one year from now, the two-year bond

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will

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when you sell it 1 year from now. Notice

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that 1 year from now the 2-year bond

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will be a 1-year bond because 1 year

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will have expired and that point it will

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be a 1-year bond. That's the reason we

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have a subscript P1T here.

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So, that means that we can solve from

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here that P2T is simply that.

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But there's an expression like the one

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we had for the 1-year bond at time T,

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there is 1 over T plus 1. We put

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expectations because we don't know the

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actual interest rate in the future.

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And then I stuck this into there and I

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we got exactly the same price that we

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got with the net present expected

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present discounted value approach, okay?

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And so, this asset pricing this

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arbitrage way of pricing things is an

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incredibly powerful tool

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that is used very extensively in

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finance. This These are simple

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calculation, but when assets gets to be

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tricky, much more complicated,

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this is is very useful.

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Then we talk about bond yields.

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And bond yields are defined

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as the constant interest rate

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that

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that is consistent with the current

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price of that particular bond.

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Okay? So, in the case of the 2-year bond

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we call the 2-year rate.

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That interest rate that is constant over

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the two periods.

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That's Okay, that's the reason I have

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squared it. It's not I1T * 1 I1T + 1.

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I squared it.

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It's not constant over time. This The

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2-year interest rate may be moving a

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lot. I mean, the the Fed just hiked by

00:11:34.360 --> 00:11:38.680
25 basis points. I'm sure all rates are

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moving at this moment. So, the rates can

00:11:38.679 --> 00:11:42.919
be moving at all points in time, but

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they But we define as the yield is at

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one point in time. You tell me the price

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of the bond. You tell me the payoff of

00:11:46.080 --> 00:11:52.120
the bond, then what is the the the

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constant interest rate that makes this

00:11:52.120 --> 00:11:57.000
price this expression equal to the

00:11:54.519 --> 00:12:00.039
actual price? That's the way we define

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the 2-year rate. That's the 2-year rate.

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And if you have a bond that pays 100 n

00:12:03.240 --> 00:12:08.159
years from now, then there would be a

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constant interest rate In n, you know,

00:12:08.159 --> 00:12:13.279
that that gives you 100 divided by 1

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plus InT

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uh

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to the n

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to the n power

00:12:17.159 --> 00:12:22.079
that will give you

00:12:19.559 --> 00:12:24.079
that you set that equal to the price the

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actual price of the bond, the one you

00:12:24.080 --> 00:12:29.520
get out of expected present discounted

00:12:26.960 --> 00:12:31.839
value or out of arbitrage, then you have

00:12:29.519 --> 00:12:34.480
found the yield or the yield to

00:12:31.839 --> 00:12:34.480
maturity.

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You know, we know what the We already

00:12:36.320 --> 00:12:39.760
got the price from the previous slide.

00:12:38.200 --> 00:12:42.600
We know that the price of this bond is

00:12:39.759 --> 00:12:44.639
going to be 100 as a 2-year bond

00:12:42.600 --> 00:12:47.000
divided by this product of 1 plus

00:12:44.639 --> 00:12:48.879
interest rate 1-year interest rate. So,

00:12:47.000 --> 00:12:50.879
this has to be equal to that. That's the

00:12:48.879 --> 00:12:52.039
way actually you calculate the 2-year

00:12:50.879 --> 00:12:52.759
yield.

00:12:52.039 --> 00:12:54.838
Uh

00:12:52.759 --> 00:12:56.919
and numerators are the same, that means

00:12:54.839 --> 00:12:59.640
the denominators have to be the same.

00:12:56.919 --> 00:13:02.639
And this implies approximately that the

00:12:59.639 --> 00:13:05.399
2-year rate is a sort of average of the

00:13:02.639 --> 00:13:08.519
expected 1-year rate, okay?

00:13:05.399 --> 00:13:10.919
So, in this case the 2-year rate is a

00:13:08.519 --> 00:13:12.679
sort of average of the 1-year rate. That

00:13:10.919 --> 00:13:15.039
means that when the

00:13:12.679 --> 00:13:17.759
when you expect the interest rate to be

00:13:15.039 --> 00:13:19.719
the 1-year rate to be rising over time

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then the 2-year rate will be above the

00:13:19.720 --> 00:13:23.440
1-year rate today.

00:13:21.960 --> 00:13:25.839
That's when the curve is We say the

00:13:23.440 --> 00:13:28.680
curve the yield curve is steep. Let me

00:13:25.839 --> 00:13:28.680
show you something.

00:13:31.480 --> 00:13:36.960
There.

00:13:33.159 --> 00:13:38.399
When the curve looks like that, so steep

00:13:36.960 --> 00:13:41.800
means that

00:13:38.399 --> 00:13:43.559
the the the later the 2-year rate the

00:13:41.799 --> 00:13:45.919
3-year Well, here in particular the

00:13:43.559 --> 00:13:48.039
3-year rate is the 2-year rate is higher

00:13:45.919 --> 00:13:49.399
than the 1-year rate. The 3-year rate is

00:13:48.039 --> 00:13:50.480
higher than the 2-year rate and so on

00:13:49.399 --> 00:13:54.079
and so forth.

00:13:50.480 --> 00:13:55.720
That happens when when you expect the

00:13:54.080 --> 00:13:56.759
market expects the interest rate to be

00:13:55.720 --> 00:13:59.040
rising

00:13:56.759 --> 00:14:02.919
over time. The 1-year rate to be rising,

00:13:59.039 --> 00:14:04.480
okay? Because Remember the 2-year rate

00:14:02.919 --> 00:14:06.399
is the average of the existing the

00:14:04.480 --> 00:14:08.920
current 1-year rate plus the expected

00:14:06.399 --> 00:14:10.799
1-year rate 1 year from now.

00:14:08.919 --> 00:14:13.000
For that average to be higher than the

00:14:10.799 --> 00:14:15.838
1-year rate now, it has to be the case

00:14:13.000 --> 00:14:17.360
that the one expected 1-year rate 1 year

00:14:15.839 --> 00:14:20.360
from now has to be higher than the

00:14:17.360 --> 00:14:22.360
current 1-year rate. Okay? So, that's

00:14:20.360 --> 00:14:23.480
what you tend to get uh

00:14:22.360 --> 00:14:25.800
that's when you get to the upward

00:14:23.480 --> 00:14:27.320
sloping term structure. And when you get

00:14:25.799 --> 00:14:29.120
a downward sloping term structure, which

00:14:27.320 --> 00:14:31.200
is the way it looks right now, actually

00:14:29.120 --> 00:14:32.919
right now looks very downward sloping.

00:14:31.200 --> 00:14:35.879
There you are. You know, it looks very

00:14:32.919 --> 00:14:38.000
downward sloping. Is people expect that

00:14:35.879 --> 00:14:40.480
we're getting to the peak of current

00:14:38.000 --> 00:14:42.399
policy rate of short-term interest rate.

00:14:40.480 --> 00:14:45.079
And so, people expect now for the

00:14:42.399 --> 00:14:46.600
interest rate to decline going forward.

00:14:45.078 --> 00:14:50.559
And that's the reason

00:14:46.600 --> 00:14:53.600
the the the 2-year rate now is lower

00:14:50.559 --> 00:14:55.119
than the 1-year rate.

00:14:53.600 --> 00:14:58.240
And the 5-year rate is lower than the

00:14:55.120 --> 00:14:58.240
2-year rate and so on.

00:14:59.480 --> 00:15:05.639
Uh as you can see here, it's very steep.

00:15:02.639 --> 00:15:08.078
Okay. Then we said, "Well, let's add

00:15:05.639 --> 00:15:10.519
risk because here Sure, here we assume

00:15:08.078 --> 00:15:12.479
that you were indifferent between

00:15:10.519 --> 00:15:13.759
investing in a completely safe 1-year

00:15:12.480 --> 00:15:15.680
bond

00:15:13.759 --> 00:15:17.000
and a and a 2-year bond in which you

00:15:15.679 --> 00:15:18.639
have to make an expectation about the

00:15:17.000 --> 00:15:20.759
price, but that price could move around.

00:15:18.639 --> 00:15:22.480
So, there's risk on that price or the on

00:15:20.759 --> 00:15:25.000
the price of 1-year

00:15:22.480 --> 00:15:25.720
bond the 1-year bond

00:15:25.000 --> 00:15:27.519
uh

00:15:25.720 --> 00:15:31.120
as of today.

00:15:27.519 --> 00:15:33.039
And then and so

00:15:31.120 --> 00:15:35.078
So, we added risk. And there are two

00:15:33.039 --> 00:15:37.599
type of risk in bonds. One is default

00:15:35.078 --> 00:15:39.439
risk that, you know, that that they had

00:15:37.600 --> 00:15:41.519
promised they would pay you 100, but it

00:15:39.440 --> 00:15:43.440
may it may be happen that they cannot

00:15:41.519 --> 00:15:45.480
pay you the 100. The corporation or the

00:15:43.440 --> 00:15:48.160
government or so on. Argentina defaults

00:15:45.480 --> 00:15:50.200
in its bonds regularly, okay?

00:15:48.159 --> 00:15:53.039
Uh for example. Uh

00:15:50.200 --> 00:15:54.839
many of the of the of the

00:15:53.039 --> 00:15:57.159
regional banks that had gone under will

00:15:54.839 --> 00:15:59.040
default on their bonds as well, okay?

00:15:57.159 --> 00:16:01.360
So, that kind of risk. But we remove

00:15:59.039 --> 00:16:02.759
that risk and we'll focus for now on the

00:16:01.360 --> 00:16:04.360
I'm going to focus mostly on the price

00:16:02.759 --> 00:16:06.559
risk because I'm going to be talking

00:16:04.360 --> 00:16:08.639
mostly about US Treasury bonds. US

00:16:06.559 --> 00:16:10.599
Treasury bonds have no default risk, we

00:16:08.639 --> 00:16:13.559
think. I mean, there could be an event

00:16:10.600 --> 00:16:15.639
in a few weeks from now, but no one

00:16:13.559 --> 00:16:18.439
expects that to be a lasting event. I

00:16:15.639 --> 00:16:20.480
mean, if it is, there's a real mess, but

00:16:18.440 --> 00:16:22.320
But anyway, but there is also price risk

00:16:20.480 --> 00:16:24.240
because you have to hold this and then

00:16:22.320 --> 00:16:25.800
sell it at the end of 1 year and you

00:16:24.240 --> 00:16:27.919
don't know exactly the price what the

00:16:25.799 --> 00:16:29.399
price will be. Okay? There's a risk

00:16:27.919 --> 00:16:32.399
associated to that.

00:16:29.399 --> 00:16:34.159
So, so that means that really you

00:16:32.399 --> 00:16:37.039
shouldn't equalize the return on the

00:16:34.159 --> 00:16:40.159
1-year bond to the return you expect to

00:16:37.039 --> 00:16:42.599
get in in the 2-year bond. You should

00:16:40.159 --> 00:16:44.240
add a little compensation for holding

00:16:42.600 --> 00:16:47.159
the 2-year bond, for going the 2-year

00:16:44.240 --> 00:16:50.600
bond route, okay? And so, rather than

00:16:47.159 --> 00:16:51.480
expect to make 1 plus I1T

00:16:50.600 --> 00:16:54.159
uh

00:16:51.480 --> 00:16:56.399
with with the 2-year bond after 1 year,

00:16:54.159 --> 00:16:57.480
you should expect to earn a little more,

00:16:56.399 --> 00:17:00.639
okay?

00:16:57.480 --> 00:17:03.759
And that's what this XB being positive

00:17:00.639 --> 00:17:05.759
reflects. And so, in that case the price

00:17:03.759 --> 00:17:07.720
the price of the 2-year bond is a little

00:17:05.759 --> 00:17:09.519
different from what we had. In fact,

00:17:07.720 --> 00:17:10.880
it's a little lower than what we had

00:17:09.519 --> 00:17:12.920
because that's the way you compensate

00:17:10.880 --> 00:17:14.520
for risk. I sell you an instrument a

00:17:12.920 --> 00:17:16.400
little cheaper than it would have been

00:17:14.519 --> 00:17:18.519
in the absence of risk,

00:17:16.400 --> 00:17:20.560
so you you expect to get a little a

00:17:18.519 --> 00:17:23.599
slightly higher return out of that,

00:17:20.559 --> 00:17:26.240
okay? So, this price is lower than the

00:17:23.599 --> 00:17:28.159
price without the risk premium here.

00:17:26.240 --> 00:17:30.679
No? That means but it's still is

00:17:28.160 --> 00:17:32.440
promising you 100, so that's exactly how

00:17:30.679 --> 00:17:33.720
you get more return out of it because

00:17:32.440 --> 00:17:34.720
you were buying something at a lower

00:17:33.720 --> 00:17:37.039
price.

00:17:34.720 --> 00:17:37.039
Okay?

00:17:43.839 --> 00:17:49.240
So, I can do the same logic now and see

00:17:46.559 --> 00:17:50.678
what the 2-year rate is, but now that I

00:17:49.240 --> 00:17:52.960
have this

00:17:50.679 --> 00:17:55.120
taking to account this risk and you have

00:17:52.960 --> 00:17:57.679
that the 2-year rate now is the average

00:17:55.119 --> 00:18:00.359
not only of the expected 1-year rate,

00:17:57.679 --> 00:18:01.360
but also includes a risk premium.

00:18:00.359 --> 00:18:03.559
Okay?

00:18:01.359 --> 00:18:05.079
And so, and that tends to be the case

00:18:03.559 --> 00:18:06.519
that the the further out in the curve

00:18:05.079 --> 00:18:09.079
you are, the larger is that risk

00:18:06.519 --> 00:18:11.160
premium. It's called term premium

00:18:09.079 --> 00:18:13.359
because term is the same as maturity,

00:18:11.160 --> 00:18:13.360
okay?

00:18:13.799 --> 00:18:16.279
Um

00:18:16.799 --> 00:18:20.240
Actually

00:18:18.640 --> 00:18:21.120
sometimes that that is negative,

00:18:20.240 --> 00:18:23.200
actually.

00:18:21.119 --> 00:18:25.479
May and and recently up to very

00:18:23.200 --> 00:18:28.679
recently. Now it's positive. But until

00:18:25.480 --> 00:18:29.960
very recently that XB was negative.

00:18:28.679 --> 00:18:32.280
And the reason for that, you don't need

00:18:29.960 --> 00:18:35.039
to understand that now, is because

00:18:32.279 --> 00:18:37.240
long-term bonds were great hedges.

00:18:35.039 --> 00:18:39.599
Uh meaning meaning, you know, if there

00:18:37.240 --> 00:18:42.200
is a for any major event, for a

00:18:39.599 --> 00:18:44.918
financial crisis or something like that,

00:18:42.200 --> 00:18:46.240
because in a financial crisis or a major

00:18:44.919 --> 00:18:49.080
disaster

00:18:46.240 --> 00:18:50.839
interest rates tend to fall.

00:18:49.079 --> 00:18:52.599
And when interest rates fall, the price

00:18:50.839 --> 00:18:55.000
of bonds go up.

00:18:52.599 --> 00:18:57.199
Okay? And and so so that was a good

00:18:55.000 --> 00:18:58.880
hedge. If you wanted to to protect your

00:18:57.200 --> 00:19:02.080
your portfolio of equities and so on

00:18:58.880 --> 00:19:04.720
against a major catastrophic major event

00:19:02.079 --> 00:19:06.839
like a financial crisis or, you know, a

00:19:04.720 --> 00:19:08.880
war or something like that, it was not a

00:19:06.839 --> 00:19:12.439
bad idea to have some long-term US

00:19:08.880 --> 00:19:14.400
Treasury bonds in your portfolio because

00:19:12.440 --> 00:19:16.000
they would tend to go up precisely when

00:19:14.400 --> 00:19:17.800
everything else was going to be losing

00:19:16.000 --> 00:19:19.919
money, okay? And so, that's the reason

00:19:17.799 --> 00:19:21.960
tend to be negative. Now that's not the

00:19:19.919 --> 00:19:23.600
case because now one of the biggest risk

00:19:21.960 --> 00:19:26.279
is inflation.

00:19:23.599 --> 00:19:27.519
And so so uh if there's an inflationary

00:19:26.279 --> 00:19:29.918
spike,

00:19:27.519 --> 00:19:31.599
then interest rate will go down up, not

00:19:29.919 --> 00:19:33.360
down. And that means the price of bonds

00:19:31.599 --> 00:19:35.000
will decline. So, they will decline at

00:19:33.359 --> 00:19:36.678
the wrong time,

00:19:35.000 --> 00:19:38.919
So, the price of bonds of long-term

00:19:36.679 --> 00:19:40.280
bonds now will tend to decline

00:19:38.919 --> 00:19:42.040
uh when everything else is also

00:19:40.279 --> 00:19:43.599
plummeting. I mean, if we get a negative

00:19:42.039 --> 00:19:45.200
if we get an inflation surprise that

00:19:43.599 --> 00:19:47.439
inflation is a lot higher than people

00:19:45.200 --> 00:19:49.440
expected, asset prices are going to

00:19:47.440 --> 00:19:51.480
decline, all of them, including

00:19:49.440 --> 00:19:55.480
long-term bonds. And that's the reason

00:19:51.480 --> 00:19:55.480
now this XB is positive.

00:19:56.119 --> 00:20:01.279
Okay, so that's I think that's where we

00:19:58.119 --> 00:20:02.879
were at in the previous lecture.

00:20:01.279 --> 00:20:06.720
Any questions about that? Then I'm going

00:20:02.880 --> 00:20:07.840
to Next step is to talk about equity.

00:20:06.720 --> 00:20:08.600
No?

00:20:07.839 --> 00:20:10.879
Yeah.

00:20:08.599 --> 00:20:12.319
Why don't we add the interest the risk

00:20:10.880 --> 00:20:14.640
to the interest rate for the one year

00:20:12.319 --> 00:20:14.639
now?

00:20:15.680 --> 00:20:19.680
Well, because next year that one for

00:20:17.720 --> 00:20:23.360
this particular bond

00:20:19.680 --> 00:20:25.320
that that bond will have no risk because

00:20:23.359 --> 00:20:26.439
it will be one year to go

00:20:25.319 --> 00:20:28.799
and at the end of that year you're going

00:20:26.440 --> 00:20:30.799
to get the 100.

00:20:28.799 --> 00:20:32.799
So, there's no risk that added. If it

00:20:30.799 --> 00:20:35.039
was a three-year bond, then you would

00:20:32.799 --> 00:20:36.240
have in two of those you would have risk

00:20:35.039 --> 00:20:37.680
premium.

00:20:36.240 --> 00:20:38.920
And but you wouldn't have it in the last

00:20:37.680 --> 00:20:40.360
one because in the last one you don't

00:20:38.920 --> 00:20:42.080
have the you're going to receive the

00:20:40.359 --> 00:20:45.559
100.

00:20:42.079 --> 00:20:47.480
If the bond could could could default

00:20:45.559 --> 00:20:48.919
so because I'm only looking at price

00:20:47.480 --> 00:20:49.839
risk in the bond.

00:20:48.920 --> 00:20:52.519
Uh uh

00:20:49.839 --> 00:20:54.639
if the bond could could default, then I

00:20:52.519 --> 00:20:56.359
would add an extra

00:20:54.640 --> 00:20:58.520
term there because it's the fall risk.

00:20:56.359 --> 00:21:00.879
But but here I'm just looking at price

00:20:58.519 --> 00:21:03.319
risk and I'm assuming the the unit of

00:21:00.880 --> 00:21:05.240
time is one year. So, just one year

00:21:03.319 --> 00:21:07.599
before it expires there's no more risk

00:21:05.240 --> 00:21:10.079
because there's no price in between

00:21:07.599 --> 00:21:11.039
and and you're going to receive a 100

00:21:10.079 --> 00:21:14.000
uh uh

00:21:11.039 --> 00:21:16.599
at the end of the year. In reality

00:21:14.000 --> 00:21:17.880
time is continuous. So, so every second

00:21:16.599 --> 00:21:19.319
there's a little bit of a risk. So, you

00:21:17.880 --> 00:21:21.240
have a little bit of that risk all the

00:21:19.319 --> 00:21:23.240
time except for the last second.

00:21:21.240 --> 00:21:24.960
Uh but but

00:21:23.240 --> 00:21:26.039
I'm looking at a simple example where

00:21:24.960 --> 00:21:29.400
you know

00:21:26.039 --> 00:21:29.399
things happen every one year. And

00:21:31.480 --> 00:21:35.039
In the book I think they mess up

00:21:33.480 --> 00:21:37.759
actually. They put the risk premium in

00:21:35.039 --> 00:21:40.200
the wrong place. But

00:21:37.759 --> 00:21:41.839
there was another question.

00:21:40.200 --> 00:21:44.000
No?

00:21:41.839 --> 00:21:44.959
Okay.

00:21:44.000 --> 00:21:47.480
So

00:21:44.960 --> 00:21:49.000
let's look at the stock prices now.

00:21:47.480 --> 00:21:50.559
Uh

00:21:49.000 --> 00:21:53.440
So, a stock price has two key

00:21:50.559 --> 00:21:55.519
differences with respect to

00:21:53.440 --> 00:21:55.519
um

00:21:56.000 --> 00:21:59.599
Well, certainly there were but two that

00:21:57.319 --> 00:22:01.119
I want to highlight.

00:21:59.599 --> 00:22:02.639
The first is that they don't pay

00:22:01.119 --> 00:22:05.039
coupons, fixed amount. They don't

00:22:02.640 --> 00:22:07.360
promise you to pay, you know, $100 two

00:22:05.039 --> 00:22:09.639
years from now or anything like that.

00:22:07.359 --> 00:22:10.759
They pay dividends.

00:22:09.640 --> 00:22:12.720
Okay?

00:22:10.759 --> 00:22:14.559
They tell you we have a policy of paying

00:22:12.720 --> 00:22:16.679
dividends and even different companies

00:22:14.559 --> 00:22:18.599
differentiate themselves by how much

00:22:16.679 --> 00:22:20.960
they promise to give you on average in

00:22:18.599 --> 00:22:22.799
dividends, but it's a promise that if

00:22:20.960 --> 00:22:24.360
everything goes as planned, they'll pay

00:22:22.799 --> 00:22:26.720
you those dividends.

00:22:24.359 --> 00:22:28.799
It's not a commitment to pay you a

00:22:26.720 --> 00:22:30.880
dividend. When it's very different from

00:22:28.799 --> 00:22:33.759
a bond. A bond says, "I'll pay you a

00:22:30.880 --> 00:22:35.080
coupon of this amount every six months."

00:22:33.759 --> 00:22:37.079
And if you don't pay that coupon, that's

00:22:35.079 --> 00:22:38.720
a default.

00:22:37.079 --> 00:22:41.279
There's nothing like that in equity.

00:22:38.720 --> 00:22:43.000
Equity you buy shares of Apple and you

00:22:41.279 --> 00:22:45.799
sort of look at the history of dividend,

00:22:43.000 --> 00:22:49.240
what what the CEO told you the last time

00:22:45.799 --> 00:22:50.720
the in the last release uh and and and

00:22:49.240 --> 00:22:51.839
you know, you you can you you think,

00:22:50.720 --> 00:22:52.799
"Okay, these are more or less going to

00:22:51.839 --> 00:22:55.119
be my dividends." But there's no

00:22:52.799 --> 00:22:57.039
commitment.

00:22:55.119 --> 00:22:58.759
They will always tell you

00:22:57.039 --> 00:23:00.480
what's their plan

00:22:58.759 --> 00:23:01.879
but it's a plan. It's not a commitment.

00:23:00.480 --> 00:23:03.279
So, that's the first thing. It doesn't

00:23:01.880 --> 00:23:05.320
have fixed coupons or anything like

00:23:03.279 --> 00:23:07.279
that. There's no commitment. And in that

00:23:05.319 --> 00:23:08.678
sense there's no sense of default

00:23:07.279 --> 00:23:10.160
because there was no commitment, so

00:23:08.679 --> 00:23:13.080
there's no default.

00:23:10.160 --> 00:23:15.560
Uh if if a company has to cut dividends

00:23:13.079 --> 00:23:16.399
to zero, that's not a default.

00:23:15.559 --> 00:23:17.960
That's

00:23:16.400 --> 00:23:20.000
conditions change. That's it. There was

00:23:17.960 --> 00:23:21.200
no commitment to that.

00:23:20.000 --> 00:23:23.240
The second

00:23:21.200 --> 00:23:25.160
feature is that they don't have a fixed

00:23:23.240 --> 00:23:28.079
terminal date.

00:23:25.160 --> 00:23:29.600
99.9999999%

00:23:28.079 --> 00:23:31.199
of the bonds do have a terminal date.

00:23:29.599 --> 00:23:32.759
They have a maturity. I mean, there's a

00:23:31.200 --> 00:23:34.679
few exceptions which are called

00:23:32.759 --> 00:23:36.960
perpetuities.

00:23:34.679 --> 00:23:39.880
That I think the US has none for

00:23:36.960 --> 00:23:40.799
example. But but but but most bonds have

00:23:39.880 --> 00:23:42.880
a

00:23:40.799 --> 00:23:44.079
uh uh a a maturity.

00:23:42.880 --> 00:23:46.040
Okay?

00:23:44.079 --> 00:23:47.879
Equity doesn't come that way. Nobody

00:23:46.039 --> 00:23:50.399
tells you buy a share of Apple you don't

00:23:47.880 --> 00:23:52.560
buy shares of Apple that

00:23:50.400 --> 00:23:54.560
they will that will be retired 30 years

00:23:52.559 --> 00:23:56.159
from now. Okay?

00:23:54.559 --> 00:23:57.919
They will be there as long as Apple's

00:23:56.160 --> 00:23:58.960
exist.

00:23:57.920 --> 00:24:00.039
Okay?

00:23:58.960 --> 00:24:02.120
Uh

00:24:00.039 --> 00:24:04.200
Now, of course, you know, if you had

00:24:02.119 --> 00:24:05.599
shares of First Republic Bank, you have

00:24:04.200 --> 00:24:07.960
nothing now.

00:24:05.599 --> 00:24:09.639
And because of that but but that was not

00:24:07.960 --> 00:24:12.160
the original plan. If First Republic

00:24:09.640 --> 00:24:13.600
Bank had been successful, you would have

00:24:12.160 --> 00:24:15.720
the the shares would have survived for a

00:24:13.599 --> 00:24:18.199
very long period of time. Okay?

00:24:15.720 --> 00:24:19.880
So so there's no sense of maturity. In

00:24:18.200 --> 00:24:22.360
principle

00:24:19.880 --> 00:24:24.480
equity can last forever.

00:24:22.359 --> 00:24:24.479
Okay?

00:24:27.480 --> 00:24:33.240
So, I'm going to use arbitrage to to to

00:24:30.759 --> 00:24:34.440
price equity.

00:24:33.240 --> 00:24:35.200
So

00:24:34.440 --> 00:24:37.480
uh

00:24:35.200 --> 00:24:38.640
let me So, let's we have the following

00:24:37.480 --> 00:24:40.599
uh

00:24:38.640 --> 00:24:41.400
portfolio of options here.

00:24:40.599 --> 00:24:44.480
Uh

00:24:41.400 --> 00:24:45.800
one is our old one-year bond.

00:24:44.480 --> 00:24:48.440
Okay? So, you can invest your dollar

00:24:45.799 --> 00:24:49.960
today in a one-year bond.

00:24:48.440 --> 00:24:51.840
The alternative I'm going to say there

00:24:49.960 --> 00:24:55.000
is some equity out there. And I'm going

00:24:51.839 --> 00:24:57.720
to call the price of that equity Q

00:24:55.000 --> 00:25:01.679
and the dividend of that e- e-

00:24:57.720 --> 00:25:01.679
equity D. Okay?

00:25:01.720 --> 00:25:06.079
So

00:25:03.920 --> 00:25:07.960
so let's price this stock by by

00:25:06.079 --> 00:25:09.480
arbitrage. So

00:25:07.960 --> 00:25:12.279
equity is risky.

00:25:09.480 --> 00:25:14.880
I mean, that is much riskier than than

00:25:12.279 --> 00:25:16.399
than than bonds unless you are into

00:25:14.880 --> 00:25:17.720
Argentinian bonds or things like that.

00:25:16.400 --> 00:25:18.759
But I mean, it's much riskier than

00:25:17.720 --> 00:25:20.759
bonds.

00:25:18.759 --> 00:25:22.879
So, there's always a risk premium and

00:25:20.759 --> 00:25:25.559
actually that itself is a trade. You

00:25:22.880 --> 00:25:28.360
trade the risk premium of equity market.

00:25:25.559 --> 00:25:30.039
So, I'm going to put an XS here. So what

00:25:28.359 --> 00:25:31.479
do you what do you expect to get from

00:25:30.039 --> 00:25:33.159
from holding

00:25:31.480 --> 00:25:35.759
Remember, arbitrage means the same

00:25:33.160 --> 00:25:39.480
holding period. So, I'm going to compare

00:25:35.759 --> 00:25:41.079
investing in a one-year safe bond

00:25:39.480 --> 00:25:44.319
versus

00:25:41.079 --> 00:25:46.519
buying equity today, buying a stock

00:25:44.319 --> 00:25:48.319
holding it for a year

00:25:46.519 --> 00:25:50.759
and then selling it there.

00:25:48.319 --> 00:25:52.720
Okay? That because that's That's I

00:25:50.759 --> 00:25:54.400
cannot do arbitrage for paying different

00:25:52.720 --> 00:25:55.759
holding periods. That's a one-year

00:25:54.400 --> 00:25:57.519
holding period.

00:25:55.759 --> 00:25:59.400
So, I'm saying this is what I'm going to

00:25:57.519 --> 00:26:01.200
get from the bond. I'm going to require

00:25:59.400 --> 00:26:03.840
some risk compensation for that because

00:26:01.200 --> 00:26:05.679
risk equity is risky. So, I'm going to

00:26:03.839 --> 00:26:07.639
want that. And this is what I'm going to

00:26:05.679 --> 00:26:09.080
get That's my return on equity I get.

00:26:07.640 --> 00:26:10.360
This is what I'm going to pay today for

00:26:09.079 --> 00:26:12.199
the stock

00:26:10.359 --> 00:26:13.919
say for a share of Apple

00:26:12.200 --> 00:26:16.240
and I'm going to get this. This is the

00:26:13.920 --> 00:26:18.000
dividend I expect to get

00:26:16.240 --> 00:26:19.559
at the end of the year

00:26:18.000 --> 00:26:21.839
and then I this is the price at which I

00:26:19.559 --> 00:26:23.359
expect to sell

00:26:21.839 --> 00:26:24.678
that share

00:26:23.359 --> 00:26:25.479
one year from now.

00:26:24.679 --> 00:26:27.360
Okay?

00:26:25.480 --> 00:26:30.079
So, that's the return I'm expecting to

00:26:27.359 --> 00:26:31.479
get from holding the share of Apple for

00:26:30.079 --> 00:26:32.119
one period.

00:26:31.480 --> 00:26:33.839
Okay?

00:26:32.119 --> 00:26:35.519
And that's what I need to compare with

00:26:33.839 --> 00:26:38.399
holding for one year

00:26:35.519 --> 00:26:40.440
one-year bond. But I want also to be

00:26:38.400 --> 00:26:42.000
compensated uh

00:26:40.440 --> 00:26:44.519
for uh

00:26:42.000 --> 00:26:46.880
risk. Okay?

00:26:44.519 --> 00:26:46.879
Good.

00:26:47.000 --> 00:26:49.679
Is this clear?

00:26:51.240 --> 00:26:53.079
Okay,

00:26:51.880 --> 00:26:54.560
good.

00:26:53.079 --> 00:26:56.279
I don't know whether silence means yes

00:26:54.559 --> 00:26:57.839
or no. But this is

00:26:56.279 --> 00:26:59.720
No, we did something like this with the

00:26:57.839 --> 00:27:02.319
two-year bond except that we didn't have

00:26:59.720 --> 00:27:04.799
a a dividend there, you know,

00:27:02.319 --> 00:27:07.639
because there was no coupon at day one.

00:27:04.799 --> 00:27:09.799
We only had a final payment of 100. But

00:27:07.640 --> 00:27:11.800
we did this already when we compare the

00:27:09.799 --> 00:27:14.519
one-year bond with holding the two-year

00:27:11.799 --> 00:27:15.960
bond for one period. We had exactly that

00:27:14.519 --> 00:27:17.559
except that there was the expected

00:27:15.960 --> 00:27:20.360
dividend there was zero because there

00:27:17.559 --> 00:27:22.000
was no payment at the intermediate date.

00:27:20.359 --> 00:27:23.879
Okay?

00:27:22.000 --> 00:27:25.799
Good. So, we we know this concept

00:27:23.880 --> 00:27:27.920
already. The only difference here is

00:27:25.799 --> 00:27:31.119
again that there is expected dividend

00:27:27.920 --> 00:27:32.960
and second that we have a risk premium

00:27:31.119 --> 00:27:34.639
here which we added for bonds, but for

00:27:32.960 --> 00:27:36.880
equity as I said it's typically much

00:27:34.640 --> 00:27:40.759
larger than for bonds, especially if

00:27:36.880 --> 00:27:40.760
you're talking about treasury bonds.

00:27:41.559 --> 00:27:45.678
So, I'm going to reorganize this to

00:27:43.000 --> 00:27:46.799
solve out for the price, this QT here.

00:27:45.679 --> 00:27:48.600
That's what I want to figure out. What

00:27:46.799 --> 00:27:49.759
is the price of the share of Apple?

00:27:48.599 --> 00:27:50.959
Okay?

00:27:49.759 --> 00:27:53.200
Well

00:27:50.960 --> 00:27:54.600
I can reorganize this which means, you

00:27:53.200 --> 00:27:57.400
know, move

00:27:54.599 --> 00:28:00.919
dollar QT to the left, divide these two

00:27:57.400 --> 00:28:02.519
guys here by 1 + I1T + XS and I get

00:28:00.920 --> 00:28:05.440
this. Okay?

00:28:02.519 --> 00:28:07.319
So, the price is equal to

00:28:05.440 --> 00:28:09.640
the discounted

00:28:07.319 --> 00:28:11.079
expected dividend. I have to discount it

00:28:09.640 --> 00:28:13.720
because I expect to receive it one year

00:28:11.079 --> 00:28:15.240
from now and I want I also compensation

00:28:13.720 --> 00:28:19.039
for risk

00:28:15.240 --> 00:28:20.679
plus the discounted value of the

00:28:19.039 --> 00:28:23.000
money I'm going to get from from selling

00:28:20.679 --> 00:28:25.480
the share of Apple one year from now.

00:28:23.000 --> 00:28:27.400
Okay? Which I also discount

00:28:25.480 --> 00:28:28.919
by the interest rate, but also with a

00:28:27.400 --> 00:28:30.080
risk premium because that's a risky

00:28:28.919 --> 00:28:31.880
investment.

00:28:30.079 --> 00:28:34.519
Okay?

00:28:31.880 --> 00:28:36.400
So, that's what we have.

00:28:34.519 --> 00:28:39.279
Now

00:28:36.400 --> 00:28:39.280
notice that

00:28:39.799 --> 00:28:44.639
at T + 1

00:28:42.919 --> 00:28:46.240
I will have an expression like that as

00:28:44.640 --> 00:28:48.120
well.

00:28:46.240 --> 00:28:50.440
Okay, again.

00:28:48.119 --> 00:28:52.719
When we did the two-year bond

00:28:50.440 --> 00:28:54.159
we didn't have an expression like that

00:28:52.720 --> 00:28:56.240
because

00:28:54.159 --> 00:28:58.159
after after one year the two-year bond

00:28:56.240 --> 00:28:59.960
was going to be a one-year bond.

00:28:58.159 --> 00:29:02.880
And so, we didn't need to think of put a

00:28:59.960 --> 00:29:04.640
price there. We just put the 100. Okay?

00:29:02.880 --> 00:29:06.919
Here is different because we said this

00:29:04.640 --> 00:29:09.720
equity never expires unless the company

00:29:06.919 --> 00:29:11.960
goes bankrupt, it's there.

00:29:09.720 --> 00:29:14.039
So, in the next date I'm going to have

00:29:11.960 --> 00:29:16.679
an expression exactly like that. I'm

00:29:14.039 --> 00:29:19.678
just going to have an expected T +

00:29:16.679 --> 00:29:22.600
dividend at T + 2 and expected price at

00:29:19.679 --> 00:29:24.120
T + 2. Okay? And so on and so forth.

00:29:22.599 --> 00:29:27.079
That means

00:29:24.119 --> 00:29:30.000
I can replace this expression here

00:29:27.079 --> 00:29:32.759
by an expression like this shifted all

00:29:30.000 --> 00:29:32.759
by one year.

00:29:33.319 --> 00:29:39.359
Okay? And I keep can keep doing that.

00:29:36.400 --> 00:29:41.240
Then if I do that, I'm going to get then

00:29:39.359 --> 00:29:42.519
two expected dividends here and then I'm

00:29:41.240 --> 00:29:44.960
going to get a

00:29:42.519 --> 00:29:46.519
uh So, I'm going to get

00:29:44.960 --> 00:29:49.079
something like this but shifted by one

00:29:46.519 --> 00:29:51.079
year and discounted by two terms in the

00:29:49.079 --> 00:29:54.039
denominator, and then I'm going to get a

00:29:51.079 --> 00:29:56.000
expected Q QT + 2.

00:29:54.039 --> 00:29:57.639
Around here, okay?

00:29:56.000 --> 00:29:59.839
Well, I can do a substitution of that as

00:29:57.640 --> 00:30:01.680
well. Again,

00:29:59.839 --> 00:30:03.319
okay? By everything shifted by two

00:30:01.680 --> 00:30:05.160
years, and so on.

00:30:03.319 --> 00:30:06.720
So, I can keep going.

00:30:05.160 --> 00:30:08.600
And I can keep going, and going, and

00:30:06.720 --> 00:30:09.519
going, and going on forever.

00:30:08.599 --> 00:30:11.439
Okay?

00:30:09.519 --> 00:30:12.279
So, if you keep doing it,

00:30:11.440 --> 00:30:15.080
you're going to end up with an

00:30:12.279 --> 00:30:18.039
expression that gives you the price of

00:30:15.079 --> 00:30:19.720
the asset as expected this

00:30:18.039 --> 00:30:22.920
present discounted value of all the

00:30:19.720 --> 00:30:24.519
future dividends you expect.

00:30:22.920 --> 00:30:26.759
Okay?

00:30:24.519 --> 00:30:30.519
You see? I I'm summing

00:30:26.759 --> 00:30:31.759
the T + 2, 3, 4, 5, and doesn't stop

00:30:30.519 --> 00:30:34.519
here.

00:30:31.759 --> 00:30:36.480
If I stop here, I'm going to have here a

00:30:34.519 --> 00:30:38.799
you know, a Q

00:30:36.480 --> 00:30:40.120
E T + N

00:30:38.799 --> 00:30:41.559
+ 1.

00:30:40.119 --> 00:30:42.839
Well, I can replace that thing again,

00:30:41.559 --> 00:30:43.879
and I can keep going, keep going

00:30:42.839 --> 00:30:45.240
forever.

00:30:43.880 --> 00:30:48.080
Okay? So, you're going to integrate the

00:30:45.240 --> 00:30:50.720
expected dividends, discounted dividends

00:30:48.079 --> 00:30:50.720
to infinity.

00:30:51.160 --> 00:30:55.480
Now, each future dividend is discounted

00:30:53.680 --> 00:30:57.080
more and more heavily because the

00:30:55.480 --> 00:30:58.400
denominator is growing, and growing, and

00:30:57.079 --> 00:31:00.960
growing, because it's further out in the

00:30:58.400 --> 00:31:03.480
future, it's worth less and less. Okay?

00:31:00.960 --> 00:31:05.000
But, still it can go on forever.

00:31:03.480 --> 00:31:07.599
And in fact, even if you if you

00:31:05.000 --> 00:31:09.240
substitute this stuff a million times,

00:31:07.599 --> 00:31:12.480
there's going to still be a little price

00:31:09.240 --> 00:31:16.079
at the very end floating around.

00:31:12.480 --> 00:31:18.039
Discounted, but it will never go away.

00:31:16.079 --> 00:31:19.240
Okay? So, it never ends. There's no

00:31:18.039 --> 00:31:21.879
maturity.

00:31:19.240 --> 00:31:21.880
They keep going.

00:31:22.559 --> 00:31:28.079
Now, I did everything up to now for

00:31:24.640 --> 00:31:29.560
nominal in nominal terms. You can do

00:31:28.079 --> 00:31:30.599
And that's the reason I

00:31:29.559 --> 00:31:31.919
didn't want to spend much time with

00:31:30.599 --> 00:31:33.359
this. You can do everything in real

00:31:31.920 --> 00:31:34.000
terms as well.

00:31:33.359 --> 00:31:35.959
Uh

00:31:34.000 --> 00:31:37.839
and and and all all that happens here is

00:31:35.960 --> 00:31:41.039
just remove the dollars, and just be

00:31:37.839 --> 00:31:42.399
careful to replace uh

00:31:41.039 --> 00:31:44.399
the nominal interest rate by the real

00:31:42.400 --> 00:31:47.040
interest rate, but nothing deep there.

00:31:44.400 --> 00:31:50.560
Okay? I can you can go to real pricing,

00:31:47.039 --> 00:31:50.559
nominal pricing, and so on.

00:31:50.599 --> 00:31:55.279
Okay? But, the the important concept is

00:31:52.640 --> 00:31:58.200
not that. It is is the fact that

00:31:55.279 --> 00:32:01.480
this that the the in principle we call

00:31:58.200 --> 00:32:04.679
that, by the way, the fundamental value

00:32:01.480 --> 00:32:06.519
of a of a of a of equity or of stock is

00:32:04.679 --> 00:32:08.280
the expected present discounted value of

00:32:06.519 --> 00:32:09.799
all the dividends. And you have to

00:32:08.279 --> 00:32:11.839
discount it by the proper discounting

00:32:09.799 --> 00:32:13.240
factor, which includes interest rate and

00:32:11.839 --> 00:32:15.639
risk premium. But, that's what we call

00:32:13.240 --> 00:32:17.759
typically fundamentals. We differentiate

00:32:15.640 --> 00:32:18.960
that from what we call sometimes, I'm

00:32:17.759 --> 00:32:20.119
going to show you an example later on,

00:32:18.960 --> 00:32:23.000
bubbles.

00:32:20.119 --> 00:32:26.359
When when the price seems to exceed

00:32:23.000 --> 00:32:28.799
any reasonable sense of fundamentals.

00:32:26.359 --> 00:32:28.799
Okay?

00:32:32.599 --> 00:32:36.799
Okay, good.

00:32:34.279 --> 00:32:40.480
Okay, let me sort of start

00:32:36.799 --> 00:32:41.919
going back to to things that that um

00:32:40.480 --> 00:32:43.400
we worry about in this course, and in

00:32:41.920 --> 00:32:45.080
fact is a big issue. I don't know what

00:32:43.400 --> 00:32:47.080
is happening to markets now. The what

00:32:45.079 --> 00:32:48.199
the Fed did was very anticipated, but

00:32:47.079 --> 00:32:50.159
but

00:32:48.200 --> 00:32:53.240
um

00:32:50.160 --> 00:32:54.480
but markets of often find a way to react

00:32:53.240 --> 00:32:57.400
to things even if things were

00:32:54.480 --> 00:32:57.400
anticipated, but

00:32:57.519 --> 00:33:01.879
What happens? So, let me ask you a

00:32:59.480 --> 00:33:03.319
following question.

00:33:01.880 --> 00:33:05.040
What is the effect What do you think is

00:33:03.319 --> 00:33:08.240
the effect

00:33:05.039 --> 00:33:09.960
of an expansionary monetary policy

00:33:08.240 --> 00:33:13.120
on the asset prices we have discussed?

00:33:09.960 --> 00:33:15.160
So, bonds and equity.

00:33:13.119 --> 00:33:16.839
Let's start with bonds

00:33:15.160 --> 00:33:18.320
first.

00:33:16.839 --> 00:33:20.119
What do you think is the effect of an

00:33:18.319 --> 00:33:21.960
expansionary monetary policy? That means

00:33:20.119 --> 00:33:24.279
a reduction in the interest rate on the

00:33:21.960 --> 00:33:27.400
price of your 1-year bond, 2-year bond,

00:33:24.279 --> 00:33:27.399
any any year you pick.

00:33:30.119 --> 00:33:33.719
We already talked about that earlier.

00:33:35.440 --> 00:33:39.799
Goes up.

00:33:36.920 --> 00:33:41.080
The price of a bond is inversely related

00:33:39.799 --> 00:33:43.200
to

00:33:41.079 --> 00:33:44.599
the interest rate because if I cut an

00:33:43.200 --> 00:33:45.679
interest rate,

00:33:44.599 --> 00:33:47.439
means

00:33:45.679 --> 00:33:49.160
a bond is something that pays the payoff

00:33:47.440 --> 00:33:52.160
is in the future.

00:33:49.160 --> 00:33:54.759
That thing in the future is worth more

00:33:52.160 --> 00:33:56.440
if the interest rate goes down.

00:33:54.759 --> 00:33:58.079
There's less discounting of it.

00:33:56.440 --> 00:33:59.640
So, the price of the bond, any bond

00:33:58.079 --> 00:34:02.159
here, will go up. The 1-year, 2-year,

00:33:59.640 --> 00:34:04.600
3-year, 5-year, all of them.

00:34:02.160 --> 00:34:06.080
They'll go up. Okay?

00:34:04.599 --> 00:34:07.759
Assuming that nothing changes as a

00:34:06.079 --> 00:34:09.440
result of the monetary policy. Look,

00:34:07.759 --> 00:34:11.239
what happens is sometimes,

00:34:09.440 --> 00:34:13.119
you know, markets think, "Oops, the Fed

00:34:11.239 --> 00:34:14.878
messed up." And that leads to lots of

00:34:13.119 --> 00:34:16.639
changes in all the term structure and

00:34:14.878 --> 00:34:18.319
things like that because

00:34:16.639 --> 00:34:20.639
they expect the market to react in a

00:34:18.320 --> 00:34:22.480
strange ways to to this mistake made by

00:34:20.639 --> 00:34:24.199
the Fed. But, here I'm saying suppose

00:34:22.480 --> 00:34:25.760
that the Fed just cuts the interest rate

00:34:24.199 --> 00:34:27.839
once, and everyone believes that the Fed

00:34:25.760 --> 00:34:31.159
will continue to do so, and so on.

00:34:27.840 --> 00:34:34.039
Well, then you're going to get uh that

00:34:31.159 --> 00:34:37.679
that the price of bonds will go up.

00:34:34.039 --> 00:34:37.679
What will happen to the price of stocks?

00:34:38.079 --> 00:34:40.918
You want to answer.

00:34:41.079 --> 00:34:45.079
Up.

00:34:43.039 --> 00:34:46.519
But, it's

00:34:45.079 --> 00:34:49.279
Well, but it's important to see that it

00:34:46.519 --> 00:34:50.878
will go up probably for two reasons.

00:34:49.280 --> 00:34:52.840
The first one

00:34:50.878 --> 00:34:54.239
is that that

00:34:52.840 --> 00:34:55.879
um

00:34:54.239 --> 00:34:58.039
is that

00:34:55.878 --> 00:35:00.159
it's also the case that a lot of the

00:34:58.039 --> 00:35:01.480
price of an equity, actually even more

00:35:00.159 --> 00:35:04.239
so than a bond,

00:35:01.480 --> 00:35:05.358
has to do with expected payoffs in the

00:35:04.239 --> 00:35:06.559
future.

00:35:05.358 --> 00:35:09.480
So, if I lower interest rate, just the

00:35:06.559 --> 00:35:11.719
effect of discounting will tend to raise

00:35:09.480 --> 00:35:13.800
the price of So, even if I don't change

00:35:11.719 --> 00:35:14.919
the expected dividends at all,

00:35:13.800 --> 00:35:15.920
the fact that the interest rate goes

00:35:14.920 --> 00:35:17.280
down,

00:35:15.920 --> 00:35:19.079
for the same reason that the price of a

00:35:17.280 --> 00:35:21.519
bond went up, the price of equity will

00:35:19.079 --> 00:35:23.519
tend to go up. Okay? So, that's exactly

00:35:21.519 --> 00:35:25.119
is the same logic.

00:35:23.519 --> 00:35:27.400
But, there's an extra kick here for

00:35:25.119 --> 00:35:29.159
equity, which is what?

00:35:27.400 --> 00:35:31.358
That bonds did not have,

00:35:29.159 --> 00:35:33.639
but equity does.

00:35:31.358 --> 00:35:35.239
At least if it is an equity that is

00:35:33.639 --> 00:35:36.519
positively related to aggregate

00:35:35.239 --> 00:35:38.799
activity, but that's what I'm assuming

00:35:36.519 --> 00:35:38.800
here.

00:35:53.800 --> 00:35:57.120
Well,

00:35:55.039 --> 00:35:59.079
yeah, that's the logic, no? Here, the

00:35:57.119 --> 00:36:00.519
expansionary monetary policy is cutting

00:35:59.079 --> 00:36:02.279
interest rate, but as a result of that,

00:36:00.519 --> 00:36:04.358
output is going up.

00:36:02.280 --> 00:36:06.359
When output is going up, sales will go

00:36:04.358 --> 00:36:08.159
up, revenues will go up, dividends will

00:36:06.358 --> 00:36:10.559
probably go up as well.

00:36:08.159 --> 00:36:12.599
So, monetary policy can have very large

00:36:10.559 --> 00:36:13.840
effect. I mean,

00:36:12.599 --> 00:36:15.679
people in financial markets are looking

00:36:13.840 --> 00:36:18.600
at the Fed all the time because it can

00:36:15.679 --> 00:36:19.759
have a big impact on the price of those

00:36:18.599 --> 00:36:21.759
assets.

00:36:19.760 --> 00:36:23.280
An equity in particular can can be very

00:36:21.760 --> 00:36:25.880
strong. And in fact, that's one of the

00:36:23.280 --> 00:36:28.680
ways monetary policy works.

00:36:25.880 --> 00:36:31.079
You know, when when when

00:36:28.679 --> 00:36:32.919
the Fed cuts interest rates,

00:36:31.079 --> 00:36:35.079
inflate it inflates the value of asset

00:36:32.920 --> 00:36:37.320
prices, and that creates more wealth,

00:36:35.079 --> 00:36:40.159
people feel richer, consume more, blah

00:36:37.320 --> 00:36:42.200
blah blah. Firms feel also richer, they

00:36:40.159 --> 00:36:43.000
invest more, and so on. That's That's it

00:36:42.199 --> 00:36:45.639
That's

00:36:43.000 --> 00:36:47.480
That's deliberate in a sense. Okay?

00:36:45.639 --> 00:36:49.719
Uh that's one of the main mechanisms

00:36:47.480 --> 00:36:52.719
through which monetary policy affects

00:36:49.719 --> 00:36:54.399
aggregate demand. Just creates wealth.

00:36:52.719 --> 00:36:56.239
And when there's too much demand too

00:36:54.400 --> 00:36:57.639
much aggregate demand, like last like is

00:36:56.239 --> 00:36:59.239
going on now, that's the reason we have

00:36:57.639 --> 00:37:02.480
inflation, and so on.

00:36:59.239 --> 00:37:05.079
You know, in 2022, the Fed went out and

00:37:02.480 --> 00:37:06.679
deliberately destroyed wealth.

00:37:05.079 --> 00:37:08.719
Because that's what that's what needed

00:37:06.679 --> 00:37:10.719
to. Raise interest rate a lot, the price

00:37:08.719 --> 00:37:13.639
of equity came down, even houses began

00:37:10.719 --> 00:37:16.000
to bubble. Okay? The price of

00:37:13.639 --> 00:37:19.079
uh of of treasury bonds also collapsed,

00:37:16.000 --> 00:37:21.159
and so on and so forth. Okay?

00:37:19.079 --> 00:37:22.840
Good.

00:37:21.159 --> 00:37:25.079
Another experiment that we did sort of

00:37:22.840 --> 00:37:26.358
early on, lecture three, four, but

00:37:25.079 --> 00:37:27.840
around there,

00:37:26.358 --> 00:37:29.559
is

00:37:27.840 --> 00:37:30.800
What happens What do you think happens

00:37:29.559 --> 00:37:32.279
when there's an increase in consumer

00:37:30.800 --> 00:37:34.280
spending?

00:37:32.280 --> 00:37:36.680
So, suppose that now, remember we had a

00:37:34.280 --> 00:37:39.800
a C 0 floating around, an autonomous

00:37:36.679 --> 00:37:42.759
consumption component, and so suppose

00:37:39.800 --> 00:37:42.760
that that goes up.

00:37:43.480 --> 00:37:47.000
What do you think happens to asset

00:37:44.519 --> 00:37:47.000
prices?

00:37:47.358 --> 00:37:51.199
And this is a big issue these days,

00:37:48.679 --> 00:37:51.199
actually.

00:37:54.079 --> 00:37:58.400
Exactly. That's right. That's That's

00:37:56.599 --> 00:38:00.119
That's very good. It depends a lot. I

00:37:58.400 --> 00:38:02.039
mean, when financial markets receive

00:38:00.119 --> 00:38:05.000
news every day, there are releases of

00:38:02.039 --> 00:38:06.320
news and of all sort of things. Okay?

00:38:05.000 --> 00:38:08.358
And and

00:38:06.320 --> 00:38:10.920
in financial markets, they people always

00:38:08.358 --> 00:38:13.159
think, "Okay, this is the news.

00:38:10.920 --> 00:38:14.519
The obvious thing for this is

00:38:13.159 --> 00:38:16.358
you know, good news, because this will

00:38:14.519 --> 00:38:17.880
tend to increase output. Output will

00:38:16.358 --> 00:38:19.079
increase dividends. That's a good good

00:38:17.880 --> 00:38:20.440
thing for

00:38:19.079 --> 00:38:21.880
for stocks."

00:38:20.440 --> 00:38:24.559
Uh

00:38:21.880 --> 00:38:26.200
But, the immediate reaction is, "Whoa,

00:38:24.559 --> 00:38:27.920
but what will the Fed do about this?

00:38:26.199 --> 00:38:29.480
Does the Fed like

00:38:27.920 --> 00:38:30.720
that we have more aggregate demand or

00:38:29.480 --> 00:38:31.800
not?"

00:38:30.719 --> 00:38:34.358
Okay?

00:38:31.800 --> 00:38:35.680
And so so so that's that's

00:38:34.358 --> 00:38:39.400
key here.

00:38:35.679 --> 00:38:41.399
And and uh so suppose that in this case,

00:38:39.400 --> 00:38:43.680
the Fed did not like

00:38:41.400 --> 00:38:45.639
the Fed like today to the Fed doesn't

00:38:43.679 --> 00:38:46.879
want more aggregate demand today.

00:38:45.639 --> 00:38:48.799
There's no central bank around the

00:38:46.880 --> 00:38:50.599
world, maybe in China, but but there's

00:38:48.800 --> 00:38:53.080
no other central bank around the world

00:38:50.599 --> 00:38:54.440
that wants more aggregate demand.

00:38:53.079 --> 00:38:57.759
Okay?

00:38:54.440 --> 00:39:00.280
So, so if if it's if if you the release

00:38:57.760 --> 00:39:02.359
is consumer

00:39:00.280 --> 00:39:03.440
are very bullish now,

00:39:02.358 --> 00:39:06.199
uh

00:39:03.440 --> 00:39:08.280
that's not good news. I mean, financial

00:39:06.199 --> 00:39:10.319
markets immediately say, "Uh-oh, we have

00:39:08.280 --> 00:39:11.240
a Fed that is watching for inflation.

00:39:10.320 --> 00:39:12.519
This means they're going to hike

00:39:11.239 --> 00:39:13.679
interest rates."

00:39:12.519 --> 00:39:15.840
Okay?

00:39:13.679 --> 00:39:19.480
So, what happens to the price of bonds

00:39:15.840 --> 00:39:21.280
then in this environment when C 0 goes

00:39:19.480 --> 00:39:22.760
up, and the Fed doesn't like it? And and

00:39:21.280 --> 00:39:24.880
the markets know that the Fed doesn't

00:39:22.760 --> 00:39:26.600
like it. The Fed may take a month to

00:39:24.880 --> 00:39:28.240
react to it, but markets react

00:39:26.599 --> 00:39:30.679
immediately, say, "Whoa, this is what

00:39:28.239 --> 00:39:32.159
the Fed will do 1 month from now."

00:39:30.679 --> 00:39:33.399
Okay?

00:39:32.159 --> 00:39:35.239
So, what do you think happens to the

00:39:33.400 --> 00:39:37.079
price of bonds

00:39:35.239 --> 00:39:38.599
if we get news that, you know, consumers

00:39:37.079 --> 00:39:41.119
are

00:39:38.599 --> 00:39:42.400
very bullish, and and and and it turns

00:39:41.119 --> 00:39:45.000
out that we also have

00:39:42.400 --> 00:39:46.480
of you know 4% or so, so we know that

00:39:45.000 --> 00:39:48.480
the Fed doesn't like more aggregate

00:39:46.480 --> 00:39:49.519
demand.

00:39:48.480 --> 00:39:52.400
What do you think will happen to the

00:39:49.519 --> 00:39:52.400
price of bonds?

00:39:56.599 --> 00:39:59.960
Well,

00:39:58.480 --> 00:40:02.240
again,

00:39:59.960 --> 00:40:03.880
the news happens say

00:40:02.239 --> 00:40:05.399
uh

00:40:03.880 --> 00:40:07.680
a week ago

00:40:05.400 --> 00:40:10.280
and the Fed moves one week later.

00:40:07.679 --> 00:40:11.599
So so markets are going to anticipate

00:40:10.280 --> 00:40:14.000
that in this case the Fed will hike

00:40:11.599 --> 00:40:15.839
interest rates.

00:40:14.000 --> 00:40:17.320
If the Fed is the markets anticipate

00:40:15.840 --> 00:40:19.640
that the Fed will hike interest rate,

00:40:17.320 --> 00:40:21.320
interest rate will go up immediately.

00:40:19.639 --> 00:40:22.719
Not the not the rate that the Fed

00:40:21.320 --> 00:40:24.160
controls, but the one-year rate, the

00:40:22.719 --> 00:40:25.799
two-year rate, the three-month rate, all

00:40:24.159 --> 00:40:28.319
those rates are going to go up

00:40:25.800 --> 00:40:30.519
immediately as a result of that.

00:40:28.320 --> 00:40:31.680
Okay? And that

00:40:30.519 --> 00:40:33.559
we know

00:40:31.679 --> 00:40:35.359
reduces the price of bonds. Bonds and

00:40:33.559 --> 00:40:36.440
interest rates are The price of a bond

00:40:35.360 --> 00:40:38.720
and the interest rates are inversely

00:40:36.440 --> 00:40:41.200
related. So the anticipation that the

00:40:38.719 --> 00:40:43.759
Fed will hike rate will lead to higher

00:40:41.199 --> 00:40:46.319
interest rates at all horizons and and

00:40:43.760 --> 00:40:50.680
and that will reduce the price of bonds.

00:40:46.320 --> 00:40:52.039
Okay? So this thing that and for equity,

00:40:50.679 --> 00:40:54.399
well, look what happened for equity

00:40:52.039 --> 00:40:56.159
here. Well, for equity you say, "Okay,

00:40:54.400 --> 00:40:58.000
well, I get the same discounting effect

00:40:56.159 --> 00:40:59.199
of the bond, which is bad news, goes

00:40:58.000 --> 00:41:00.480
down."

00:40:59.199 --> 00:41:01.960
And

00:41:00.480 --> 00:41:03.639
and what about The good news is the

00:41:01.960 --> 00:41:05.000
dividend, no? Because now I have more

00:41:03.639 --> 00:41:07.319
consumers.

00:41:05.000 --> 00:41:09.320
Well, that depends on how much the Fed

00:41:07.320 --> 00:41:11.960
dislikes this stuff because if the Fed

00:41:09.320 --> 00:41:13.440
does this, that mean it offsets it fully

00:41:11.960 --> 00:41:16.199
offsets

00:41:13.440 --> 00:41:17.960
the the effect on aggregate demand.

00:41:16.199 --> 00:41:19.719
Increasing this zero shift IS to the

00:41:17.960 --> 00:41:21.519
right, that would have increased output

00:41:19.719 --> 00:41:23.159
to here. The Fed doesn't want more

00:41:21.519 --> 00:41:24.639
output, so we will hike interest rate up

00:41:23.159 --> 00:41:25.519
to the point in which output doesn't go

00:41:24.639 --> 00:41:27.119
up.

00:41:25.519 --> 00:41:28.880
That means dividends are not going to go

00:41:27.119 --> 00:41:30.759
up either.

00:41:28.880 --> 00:41:33.320
So we get just a negative effect of the

00:41:30.760 --> 00:41:34.640
discounting and we don't get the benefit

00:41:33.320 --> 00:41:36.600
of the extra activity that would have

00:41:34.639 --> 00:41:39.799
come from having consumers that are more

00:41:36.599 --> 00:41:41.559
optimistic and so on. Okay?

00:41:39.800 --> 00:41:42.840
So this is actually this has happened a

00:41:41.559 --> 00:41:43.400
lot

00:41:42.840 --> 00:41:45.400
uh

00:41:43.400 --> 00:41:47.680
over the last few months.

00:41:45.400 --> 00:41:49.280
This is an environment people call it's

00:41:47.679 --> 00:41:50.559
an environment where good news is bad

00:41:49.280 --> 00:41:51.480
news.

00:41:50.559 --> 00:41:52.960
Okay?

00:41:51.480 --> 00:41:54.760
Good news about aggregate demand,

00:41:52.960 --> 00:41:56.599
consumers are happy, blah blah blah, is

00:41:54.760 --> 00:41:58.800
bad news or labor markets are very

00:41:56.599 --> 00:42:00.360
tight, wages are going up.

00:41:58.800 --> 00:42:01.680
All things that sound wonderful in other

00:42:00.360 --> 00:42:03.720
environments

00:42:01.679 --> 00:42:06.719
sound terrible news for the financial

00:42:03.719 --> 00:42:06.719
markets. Okay?

00:42:06.960 --> 00:42:10.360
For most, I mean there's difference in

00:42:08.559 --> 00:42:12.480
different sectors and so on, but but for

00:42:10.360 --> 00:42:14.079
the aggregate, for the average,

00:42:12.480 --> 00:42:16.639
it's bad news. So this is an environment

00:42:14.079 --> 00:42:17.759
where good news is bad news. Good news

00:42:16.639 --> 00:42:19.279
about aggregate demand, you have to be

00:42:17.760 --> 00:42:21.200
specific about what. Good news about

00:42:19.280 --> 00:42:23.040
aggregate demand is bad news

00:42:21.199 --> 00:42:24.960
for asset markets.

00:42:23.039 --> 00:42:27.480
It's not always like that.

00:42:24.960 --> 00:42:28.920
If you're in a recession,

00:42:27.480 --> 00:42:30.400
the Fed doesn't want to fight that. It

00:42:28.920 --> 00:42:31.800
wants to have more aggregate demand. So

00:42:30.400 --> 00:42:33.280
if you get good news about aggregate

00:42:31.800 --> 00:42:34.400
demand, that's very good news for asset

00:42:33.280 --> 00:42:36.680
prices

00:42:34.400 --> 00:42:38.400
because the Fed will not offset that and

00:42:36.679 --> 00:42:41.239
you get the positive effect of the extra

00:42:38.400 --> 00:42:43.800
dividends and things like that. Okay?

00:42:41.239 --> 00:42:43.799
So

00:42:43.880 --> 00:42:47.960
Okay.

00:42:45.639 --> 00:42:49.920
Another component that is that moves

00:42:47.960 --> 00:42:52.880
asset prices a lot. So monetary policy

00:42:49.920 --> 00:42:54.320
moves asset prices a lot. Okay? And and

00:42:52.880 --> 00:42:55.559
monetary but monetary policy doesn't

00:42:54.320 --> 00:42:58.760
happen in

00:42:55.559 --> 00:43:00.759
some separate isolated space. It it it

00:42:58.760 --> 00:43:03.880
reacts to news about the economy, about

00:43:00.760 --> 00:43:07.440
consumers, about firms, about regional

00:43:03.880 --> 00:43:11.920
banks, all sort of things. Okay?

00:43:07.440 --> 00:43:13.360
Uh another big driver of asset prices is

00:43:11.920 --> 00:43:15.880
this guy here

00:43:13.360 --> 00:43:17.519
of of equity in particular

00:43:15.880 --> 00:43:18.720
is this risk premium.

00:43:17.519 --> 00:43:21.920
Okay?

00:43:18.719 --> 00:43:23.679
So that risk premium can move a lot

00:43:21.920 --> 00:43:25.920
and and it's an important driver of

00:43:23.679 --> 00:43:28.559
asset prices.

00:43:25.920 --> 00:43:30.880
This index, this is the it's called VIX.

00:43:28.559 --> 00:43:32.119
VIX is I'm not going to explain what it

00:43:30.880 --> 00:43:34.280
is, but

00:43:32.119 --> 00:43:37.239
people call it so you get a the picture,

00:43:34.280 --> 00:43:38.920
an index of fear in an equity market. It

00:43:37.239 --> 00:43:39.919
it it's it's done

00:43:38.920 --> 00:43:42.000
Well, I'm not going to tell you what it

00:43:39.920 --> 00:43:43.320
is. It's it's based on option prices and

00:43:42.000 --> 00:43:45.360
so on.

00:43:43.320 --> 00:43:47.160
Uh so this is

00:43:45.360 --> 00:43:48.800
this is, you know, when people realize

00:43:47.159 --> 00:43:51.480
that COVID

00:43:48.800 --> 00:43:54.080
was coming and so what you see is that

00:43:51.480 --> 00:43:56.320
this thing exploded up.

00:43:54.079 --> 00:43:58.159
Big big risk off.

00:43:56.320 --> 00:44:00.160
That's a massive spike in the little

00:43:58.159 --> 00:44:01.639
excess.

00:44:00.159 --> 00:44:03.279
Well, not surprisingly look what

00:44:01.639 --> 00:44:06.039
happened to equity.

00:44:03.280 --> 00:44:07.840
You know, collapsed by 35% or so.

00:44:06.039 --> 00:44:09.320
Part of that was expected dividends,

00:44:07.840 --> 00:44:11.800
blah blah blah,

00:44:09.320 --> 00:44:14.440
but a lot of it was the risk off.

00:44:11.800 --> 00:44:16.480
And it's called risk off when

00:44:14.440 --> 00:44:20.320
markets are very fearful. They don't

00:44:16.480 --> 00:44:22.760
want to take risks, risk off. Okay? Uh

00:44:20.320 --> 00:44:24.120
the recovery actually also had a lot to

00:44:22.760 --> 00:44:26.560
do with

00:44:24.119 --> 00:44:27.880
the recovery on the risk environment.

00:44:26.559 --> 00:44:29.440
People were sort of

00:44:27.880 --> 00:44:31.440
getting used to the thing.

00:44:29.440 --> 00:44:33.720
But that recovery also was a result of

00:44:31.440 --> 00:44:35.800
very aggressive monetary policy. The Fed

00:44:33.719 --> 00:44:38.319
tried to offset this by it cutting

00:44:35.800 --> 00:44:40.400
interest rates very aggressively and

00:44:38.320 --> 00:44:42.120
that also gave a boost to asset prices.

00:44:40.400 --> 00:44:43.519
In fact, they did so much that we ended

00:44:42.119 --> 00:44:46.159
up with a big

00:44:43.519 --> 00:44:47.199
lots of overvaluation in asset prices

00:44:46.159 --> 00:44:49.440
and then that's the reason when they

00:44:47.199 --> 00:44:50.879
hiked rates, so we had big a big decline

00:44:49.440 --> 00:44:53.760
in asset prices

00:44:50.880 --> 00:44:53.760
as a result. Okay?

00:44:54.280 --> 00:44:58.160
What is this? Ah, look, this is

00:44:57.079 --> 00:45:00.199
you know

00:44:58.159 --> 00:45:02.440
over the weekend

00:45:00.199 --> 00:45:03.519
over the weekend the

00:45:02.440 --> 00:45:04.800
I I

00:45:03.519 --> 00:45:06.920
we talked about this in the previous

00:45:04.800 --> 00:45:09.720
lecture

00:45:06.920 --> 00:45:11.159
um essentially the First Republic Bank

00:45:09.719 --> 00:45:14.839
went under

00:45:11.159 --> 00:45:18.399
uh and JP Morgan absorbed it.

00:45:14.840 --> 00:45:20.800
Uh so people thought that um

00:45:18.400 --> 00:45:22.639
that on Monday was was good because you

00:45:20.800 --> 00:45:26.160
know, people thought that

00:45:22.639 --> 00:45:28.719
this mini crisis was over.

00:45:26.159 --> 00:45:31.759
Well, yesterday

00:45:28.719 --> 00:45:33.919
uh it turns out that that

00:45:31.760 --> 00:45:36.120
two other regional banks, their shares

00:45:33.920 --> 00:45:38.480
began to collapse in the same way as the

00:45:36.119 --> 00:45:41.799
First Republic Bank shares

00:45:38.480 --> 00:45:43.800
collapsed the week before. Okay? So

00:45:41.800 --> 00:45:45.760
panic immediately set in. So the VIX,

00:45:43.800 --> 00:45:49.000
the fear index

00:45:45.760 --> 00:45:51.480
This is intraday. So markets open here

00:45:49.000 --> 00:45:54.639
and and the shares of this this this two

00:45:51.480 --> 00:45:56.280
banks began to decline very rapidly

00:45:54.639 --> 00:45:58.319
and so

00:45:56.280 --> 00:46:00.400
VIX went up a lot.

00:45:58.320 --> 00:46:04.080
And what you do This is SP This is the

00:46:00.400 --> 00:46:07.440
main This is the SPX, the the main SP

00:46:04.079 --> 00:46:09.400
S&P 500. It's the main price index

00:46:07.440 --> 00:46:11.400
equity price index in the US

00:46:09.400 --> 00:46:13.358
immediately declined.

00:46:11.400 --> 00:46:14.440
Okay? So it's a That's the excess

00:46:13.358 --> 00:46:16.480
moving.

00:46:14.440 --> 00:46:18.000
Here excess move up

00:46:16.480 --> 00:46:20.039
little X

00:46:18.000 --> 00:46:21.840
and then it began to come down and the

00:46:20.039 --> 00:46:25.000
markets began to recover.

00:46:21.840 --> 00:46:26.600
So this risk on and off is a is a very

00:46:25.000 --> 00:46:29.679
big driver

00:46:26.599 --> 00:46:29.679
of equity prices.

00:46:32.039 --> 00:46:36.400
This is one of the banks actually

00:46:34.159 --> 00:46:37.679
that was in trouble.

00:46:36.400 --> 00:46:39.639
Uh

00:46:37.679 --> 00:46:42.399
You you see that

00:46:39.639 --> 00:46:44.440
but by the end of the day this this this

00:46:42.400 --> 00:46:48.079
this is

00:46:44.440 --> 00:46:49.639
PacWest. PacWest had the decline by 28%

00:46:48.079 --> 00:46:51.279
by the end of the day. But you see

00:46:49.639 --> 00:46:53.440
things look very weird here. They don't

00:46:51.280 --> 00:46:55.600
look like normal prices.

00:46:53.440 --> 00:46:57.480
Okay? Here they look like normal prices.

00:46:55.599 --> 00:46:59.039
They're moving all the time.

00:46:57.480 --> 00:47:00.358
Here they don't.

00:46:59.039 --> 00:47:02.119
What happens is that these prices

00:47:00.358 --> 00:47:04.480
decline so rapidly that they they

00:47:02.119 --> 00:47:06.000
trigger what is called circuit breakers.

00:47:04.480 --> 00:47:08.159
So the

00:47:06.000 --> 00:47:09.920
you cannot trade those those shares when

00:47:08.159 --> 00:47:12.358
they decline too rapidly. And that's

00:47:09.920 --> 00:47:14.440
done deliberately so this little X

00:47:12.358 --> 00:47:17.159
doesn't get completely out of control.

00:47:14.440 --> 00:47:19.639
People to calm down. Okay?

00:47:17.159 --> 00:47:21.199
And so it triggered several times.

00:47:19.639 --> 00:47:23.079
Just as

00:47:21.199 --> 00:47:25.439
the the whole idea is that people calm

00:47:23.079 --> 00:47:25.440
down.

00:47:26.199 --> 00:47:29.559
Is there a question? Yeah, there's some

00:47:28.000 --> 00:47:30.920
of us like

00:47:29.559 --> 00:47:32.440
The previous or this one? Yeah, the

00:47:30.920 --> 00:47:33.519
previous one.

00:47:32.440 --> 00:47:35.599
Is

00:47:33.519 --> 00:47:37.480
Are either of them dependent on the

00:47:35.599 --> 00:47:40.440
other or are they more just showing the

00:47:37.480 --> 00:47:43.199
same sort of trend? No, no. Okay, it it

00:47:40.440 --> 00:47:46.599
doesn't a good question. Uh uh

00:47:43.199 --> 00:47:49.279
This is the risk component only. So this

00:47:46.599 --> 00:47:50.839
is more independent what I'm saying.

00:47:49.280 --> 00:47:51.920
When this guy goes up, if nothing else

00:47:50.840 --> 00:47:53.720
happens,

00:47:51.920 --> 00:47:55.680
uh this will decline because you're

00:47:53.719 --> 00:47:57.159
discounting things more heavily.

00:47:55.679 --> 00:47:58.519
But it is true that there were some

00:47:57.159 --> 00:48:00.559
common elements. Like there there are

00:47:58.519 --> 00:48:02.440
also common elements, which is people

00:48:00.559 --> 00:48:04.920
got very worried about having another

00:48:02.440 --> 00:48:07.559
regional bank collapsing and so on. And

00:48:04.920 --> 00:48:09.720
so that that also created fear about the

00:48:07.559 --> 00:48:11.519
economy, which is an independent reason

00:48:09.719 --> 00:48:14.159
for this to decline. And normally in

00:48:11.519 --> 00:48:17.119
recessions as well, this risk in

00:48:14.159 --> 00:48:19.559
appetite is is is is lower. So so you're

00:48:17.119 --> 00:48:21.880
right that it's a common component. But

00:48:19.559 --> 00:48:23.679
the point I was highlighting is that

00:48:21.880 --> 00:48:26.160
is that this VIX sort of is a big

00:48:23.679 --> 00:48:28.440
driver. It has a big impact on asset

00:48:26.159 --> 00:48:29.960
prices.

00:48:28.440 --> 00:48:32.720
But it's not the cause.

00:48:29.960 --> 00:48:34.400
It was an event that caused both, but

00:48:32.719 --> 00:48:37.358
the fact that this event came with this

00:48:34.400 --> 00:48:39.920
biggest spike in in the VIX meant that

00:48:37.358 --> 00:48:41.840
that the impact on the equity index was

00:48:39.920 --> 00:48:43.760
was larger than if it had been only news

00:48:41.840 --> 00:48:45.079
about the economy, meaning that there

00:48:43.760 --> 00:48:46.520
was a recession ahead or something like

00:48:45.079 --> 00:48:48.759
that.

00:48:46.519 --> 00:48:51.480
And let me just finish with a with with

00:48:48.760 --> 00:48:52.600
the opposite phenomenon.

00:48:51.480 --> 00:48:54.559
You know,

00:48:52.599 --> 00:48:56.839
I was talking in episodes of fear, but

00:48:54.559 --> 00:48:58.920
sometimes markets get very carried away

00:48:56.840 --> 00:49:01.519
in the opposite direction. Okay? And

00:48:58.920 --> 00:49:03.159
here I'm showing you you know, examples.

00:49:01.519 --> 00:49:05.079
I put together this picture many years

00:49:03.159 --> 00:49:08.279
back and now Deutsche Bank keeps

00:49:05.079 --> 00:49:10.119
updating it, which is it shows you some

00:49:08.280 --> 00:49:11.840
some It seems that the world needs a

00:49:10.119 --> 00:49:13.319
bubble somewhere.

00:49:11.840 --> 00:49:16.720
And then here it shows you several sort

00:49:13.320 --> 00:49:18.280
of big asset valuations, you know, look

00:49:16.719 --> 00:49:20.159
500%.

00:49:18.280 --> 00:49:22.040
This here is the Nikkei. I mean, it was

00:49:20.159 --> 00:49:24.440
enormous appreciation of the Nikkei.

00:49:22.039 --> 00:49:26.279
Here was Bitcoin. Then it collapsed.

00:49:24.440 --> 00:49:28.039
Okay? They always end up bad. When you

00:49:26.280 --> 00:49:31.480
never you see this big sort of a spiking

00:49:28.039 --> 00:49:34.440
up, they almost always end up quite

00:49:31.480 --> 00:49:36.240
poorly. Now, this is

00:49:34.440 --> 00:49:37.880
is much more likely that it happens in

00:49:36.239 --> 00:49:38.879
equity than in bonds. In bonds, it

00:49:37.880 --> 00:49:40.320
cannot happen because there is a

00:49:38.880 --> 00:49:43.000
terminal date,

00:49:40.320 --> 00:49:44.440
a terminal value. So, so what happens

00:49:43.000 --> 00:49:47.079
with these kind of things, people dream

00:49:44.440 --> 00:49:48.519
that the value go will go to infinity.

00:49:47.079 --> 00:49:50.199
No, and it could because the thing will

00:49:48.519 --> 00:49:51.759
last to infinity and and you know, the

00:49:50.199 --> 00:49:52.799
price could go to infinity. For a bond,

00:49:51.760 --> 00:49:54.320
that cannot happen because it has a

00:49:52.800 --> 00:49:55.519
terminal date and at that date they're

00:49:54.320 --> 00:49:56.480
going to pay you 100, so it can't

00:49:55.519 --> 00:49:59.119
happen.

00:49:56.480 --> 00:50:01.559
But for equity, people's imagination can

00:49:59.119 --> 00:50:04.239
run very wild. In fact, there is a

00:50:01.559 --> 00:50:06.320
famous bubble, the South Sea Bubble.

00:50:04.239 --> 00:50:08.439
It's a company in the UK.

00:50:06.320 --> 00:50:10.960
It is a famous for many reasons, but but

00:50:08.440 --> 00:50:13.400
one of them is that Isaac Newton got

00:50:10.960 --> 00:50:14.400
involved in in this one. And and you

00:50:13.400 --> 00:50:16.680
know,

00:50:14.400 --> 00:50:18.480
he got carried away. He he sold, he made

00:50:16.679 --> 00:50:21.639
a profit, you know, he sold the shares

00:50:18.480 --> 00:50:22.880
at 7,000. He profited 3,500 pounds,

00:50:21.639 --> 00:50:24.519
which must have been an enormous amount

00:50:22.880 --> 00:50:26.680
of money at the time.

00:50:24.519 --> 00:50:29.159
Prices kept going up,

00:50:26.679 --> 00:50:31.440
couldn't resist, went back in, ended up

00:50:29.159 --> 00:50:33.399
losing 20,000 pounds, which must have

00:50:31.440 --> 00:50:34.960
been a lot of money. So, he famously

00:50:33.400 --> 00:50:36.920
said, "I can calculate the motions of

00:50:34.960 --> 00:50:38.920
the heavenly bodies, but not the madness

00:50:36.920 --> 00:50:39.840
of people." It's all about expectations,

00:50:38.920 --> 00:50:42.480
okay?

00:50:39.840 --> 00:50:42.480
Let me stop here.