Okay, so let me let me continue with the
the topic of the previous lecture, which
is asset pricing.
And we said the the tricky thing with
asset pricing is that
the payoff
of having an asset comes in the future.
And that that that implies
at least two things.
The first one is that
we need to have a method to value
returns in the future
as of today.
Okay? So, what is the equivalent to?
After all, if you want to buy a
financial asset, you need to pay for it
today with dollars of today, and you are
expected to receive some payoff in the
future. You need to be able to compare
these two things.
And the second is that is related is
that because this payoff is in the
future, you need to have expectations
about it. Okay? So, those are the two
concepts
we play with.
Um
and and the and and there's a third
related concept, which is because it
comes in the future, many things can
happen in between, and so there's also a
concept of risk. Okay? Those are the
three
elements we discuss.
And
remember we did I'm going to go very
quickly over what we did in the previous
lecture because I could see some faces.
Uh so so let me go quickly over that and
then then continue with equity, uh which
was the next step. Um
So, the first step was says, "Okay,
ignore the expectations part for now and
risk and so on. Assume that you know the
future." And we ask the question,
uh well, how do we value a dollar next
year?
Uh and in particular, do we want the
question, is it equivalent to having a
dollar today?
And the answer quickly became no because
imagine that you had the dollar today,
then you can invest it for a year and
you get the return of the
the one-year interest rate return.
So, with $1 today, you can do more than
with $1 in the future.
In fact, that calculation
gave us the exact recipe to
valuing a dollar in the future because
in order to get a dollar in the future,
I don't need a dollar today. I need one
over one plus the interest rate.
Uh I invest this in in the one-year
bond, uh and and I get a return of that
over that amount, that gives you exactly
a dollar in the future. Okay? So, that
gives us a very natural way of valuing a
dollar next year, it's just one over one
plus the interest rate. And by the same
logic, if I have a dollar today and I
want to invest it for two years, well,
I'm going to earn that interest rate for
the first year, and then I'm going to
learn that earn that interest rate on
the full product, not not on the
original dollar, in the on the one plus
IT dollars, I'm going to
earn one plus IT plus one.
And and and so I can generate sort of a
lot of
you know, if the interest rate is 10% on
average, a dollar today generates 1.21
uh dollars two years from now. So, that
tells you by the same logic that one
over 1.21 dollars
uh
today is equivalent to $1 in the future.
Okay?
So, then we said, "Let's pick a very
general asset, an asset that has you
know, that pays
ZT dollars
uh this year, then ZT plus one dollars
one year from now, ZT plus two dollars
two years from now, and so on and so
forth up to n years ahead. Uh well, what
is the value of that asset today? Well,
you apply exactly the same logic that we
apply here for every single uh year in
the future,
and you get that's that's the the Let's
call the present present discounted
value
uh
of those cash flows, that gives you the
value today. Okay? Present discounted,
those are the discount factors, one over
and then that's the value that you get
out of that. So, that asset
has that present discounted value of uh
future cash flows,
and uh
that should be more or less the price
that you are willing to pay for that
asset. Okay?
Uh and then we introduce expectations
and okay, well, but we're talking about
cash flows in the future, in many cases,
we don't know. Well, we don't know two
things. First, we don't know
what the cash flows may be.
In a very safe bond, you do know the
cash flow, but but but almost any other
asset, you don't know exactly the cash
flows you receive, and you don't know
what the future interest rates, one-year
interest rate will be.
Okay?
So, that took us to the concept of
expected present discounted value, in
which you just replace all the things we
don't know today for the expectations of
those things. Okay? So, we don't know
the cash flows in the future, that's the
reason
but we have an expectation,
that's that's what you put there, and uh
we don't know the future we know the
current interest rate, but we don't know
the less
than it was when the interest rate was a
little lower. Okay?
Okay, and then we look at a two-year
bond, a bond that pays nothing up to two
years from now, and we said, "Well, two
years from now pays 100 and then
matures." Well, the price of that bond
will be
you know, this. Okay? And notice that in
this case, the price of a two-year bond
at time t goes down if the either of the
one-year rates goes up. Okay? It can be
the first this year's one-year rate, or
then maybe that's the expectation that
the one-year rate uh
next year will go up. Okay?
Good.
Then I introduce an important concept,
which is this concept of arbitrage
pricing.
Okay? Which is
uh two instruments
uh
um
should give you sort of the same
interest rate. We're leaving risk
considerations aside. It should give you
the same return
when you compare them
uh um
uh over the same maturity. Okay? So,
in this particular example, I said,
"Look,
a one-year bond
and a two-year bond that you invest you
hold for only one year should give you
more or less the same return."
Okay?
So so
so that means
that
this is the return you get from a dollar
invested in a one-year bond,
okay? Should be equal to the return you
get
by investing in a in a two-year bond and
selling that bond after one year.
And that's the expression we had here.
Okay?
If you this is what you pay for a for a
for a two-year bond, and this is what
you expect uh uh
to to be paid for that bond when you
sell it one year from now. Notice that
one year from now, the two-year bond
will
when you sell it 1 year from now. Notice
that 1 year from now the 2-year bond
will be a 1-year bond because 1 year
will have expired and that point it will
be a 1-year bond. That's the reason we
have a subscript P1T here.
So, that means that we can solve from
here that P2T is simply that.
But there's an expression like the one
we had for the 1-year bond at time T,
there is 1 over T plus 1. We put
expectations because we don't know the
actual interest rate in the future.
And then I stuck this into there and I
we got exactly the same price that we
got with the net present expected
present discounted value approach, okay?
And so, this asset pricing this
arbitrage way of pricing things is an
incredibly powerful tool
that is used very extensively in
finance. This These are simple
calculation, but when assets gets to be
tricky, much more complicated,
this is is very useful.
Then we talk about bond yields.
And bond yields are defined
as the constant interest rate
that
that is consistent with the current
price of that particular bond.
Okay? So, in the case of the 2-year bond
we call the 2-year rate.
That interest rate that is constant over
the two periods.
That's Okay, that's the reason I have
squared it. It's not I1T * 1 I1T + 1.
I squared it.
It's not constant over time. This The
2-year interest rate may be moving a
lot. I mean, the the Fed just hiked by
25 basis points. I'm sure all rates are
moving at this moment. So, the rates can
be moving at all points in time, but
they But we define as the yield is at
one point in time. You tell me the price
of the bond. You tell me the payoff of
the bond, then what is the the the
constant interest rate that makes this
price this expression equal to the
actual price? That's the way we define
the 2-year rate. That's the 2-year rate.
And if you have a bond that pays 100 n
years from now, then there would be a
constant interest rate In n, you know,
that that gives you 100 divided by 1
plus InT
uh
to the n
to the n power
that will give you
that you set that equal to the price the
actual price of the bond, the one you
get out of expected present discounted
value or out of arbitrage, then you have
found the yield or the yield to
maturity.
You know, we know what the We already
got the price from the previous slide.
We know that the price of this bond is
going to be 100 as a 2-year bond
divided by this product of 1 plus
interest rate 1-year interest rate. So,
this has to be equal to that. That's the
way actually you calculate the 2-year
yield.
Uh
and numerators are the same, that means
the denominators have to be the same.
And this implies approximately that the
2-year rate is a sort of average of the
expected 1-year rate, okay?
So, in this case the 2-year rate is a
sort of average of the 1-year rate. That
means that when the
when you expect the interest rate to be
the 1-year rate to be rising over time
then the 2-year rate will be above the
1-year rate today.
That's when the curve is We say the
curve the yield curve is steep. Let me
show you something.
There.
When the curve looks like that, so steep
means that
the the the later the 2-year rate the
3-year Well, here in particular the
3-year rate is the 2-year rate is higher
than the 1-year rate. The 3-year rate is
higher than the 2-year rate and so on
and so forth.
That happens when when you expect the
market expects the interest rate to be
rising
over time. The 1-year rate to be rising,
okay? Because Remember the 2-year rate
is the average of the existing the
current 1-year rate plus the expected
1-year rate 1 year from now.
For that average to be higher than the
1-year rate now, it has to be the case
that the one expected 1-year rate 1 year
from now has to be higher than the
current 1-year rate. Okay? So, that's
what you tend to get uh
that's when you get to the upward
sloping term structure. And when you get
a downward sloping term structure, which
is the way it looks right now, actually
right now looks very downward sloping.
There you are. You know, it looks very
downward sloping. Is people expect that
we're getting to the peak of current
policy rate of short-term interest rate.
And so, people expect now for the
interest rate to decline going forward.
And that's the reason
the the the 2-year rate now is lower
than the 1-year rate.
And the 5-year rate is lower than the
2-year rate and so on.
Uh as you can see here, it's very steep.
Okay. Then we said, "Well, let's add
risk because here Sure, here we assume
that you were indifferent between
investing in a completely safe 1-year
bond
and a and a 2-year bond in which you
have to make an expectation about the
price, but that price could move around.
So, there's risk on that price or the on
the price of 1-year
bond the 1-year bond
uh
as of today.
And then and so
So, we added risk. And there are two
type of risk in bonds. One is default
risk that, you know, that that they had
promised they would pay you 100, but it
may it may be happen that they cannot
pay you the 100. The corporation or the
government or so on. Argentina defaults
in its bonds regularly, okay?
Uh for example. Uh
many of the of the of the
regional banks that had gone under will
default on their bonds as well, okay?
So, that kind of risk. But we remove
that risk and we'll focus for now on the
I'm going to focus mostly on the price
risk because I'm going to be talking
mostly about US Treasury bonds. US
Treasury bonds have no default risk, we
think. I mean, there could be an event
in a few weeks from now, but no one
expects that to be a lasting event. I
mean, if it is, there's a real mess, but
But anyway, but there is also price risk
because you have to hold this and then
sell it at the end of 1 year and you
don't know exactly the price what the
price will be. Okay? There's a risk
associated to that.
So, so that means that really you
shouldn't equalize the return on the
1-year bond to the return you expect to
get in in the 2-year bond. You should
add a little compensation for holding
the 2-year bond, for going the 2-year
bond route, okay? And so, rather than
expect to make 1 plus I1T
uh
with with the 2-year bond after 1 year,
you should expect to earn a little more,
okay?
And that's what this XB being positive
reflects. And so, in that case the price
the price of the 2-year bond is a little
different from what we had. In fact,
it's a little lower than what we had
because that's the way you compensate
for risk. I sell you an instrument a
little cheaper than it would have been
in the absence of risk,
so you you expect to get a little a
slightly higher return out of that,
okay? So, this price is lower than the
price without the risk premium here.
No? That means but it's still is
promising you 100, so that's exactly how
you get more return out of it because
you were buying something at a lower
price.
Okay?
So, I can do the same logic now and see
what the 2-year rate is, but now that I
have this
taking to account this risk and you have
that the 2-year rate now is the average
not only of the expected 1-year rate,
but also includes a risk premium.
Okay?
And so, and that tends to be the case
that the the further out in the curve
you are, the larger is that risk
premium. It's called term premium
because term is the same as maturity,
okay?
Um
Actually
sometimes that that is negative,
actually.
May and and recently up to very
recently. Now it's positive. But until
very recently that XB was negative.
And the reason for that, you don't need
to understand that now, is because
long-term bonds were great hedges.
Uh meaning meaning, you know, if there
is a for any major event, for a
financial crisis or something like that,
because in a financial crisis or a major
disaster
interest rates tend to fall.
And when interest rates fall, the price
of bonds go up.
Okay? And and so so that was a good
hedge. If you wanted to to protect your
your portfolio of equities and so on
against a major catastrophic major event
like a financial crisis or, you know, a
war or something like that, it was not a
bad idea to have some long-term US
Treasury bonds in your portfolio because
they would tend to go up precisely when
everything else was going to be losing
money, okay? And so, that's the reason
tend to be negative. Now that's not the
case because now one of the biggest risk
is inflation.
And so so uh if there's an inflationary
spike,
then interest rate will go down up, not
down. And that means the price of bonds
will decline. So, they will decline at
the wrong time,
So, the price of bonds of long-term
bonds now will tend to decline
uh when everything else is also
plummeting. I mean, if we get a negative
if we get an inflation surprise that
inflation is a lot higher than people
expected, asset prices are going to
decline, all of them, including
long-term bonds. And that's the reason
now this XB is positive.
Okay, so that's I think that's where we
were at in the previous lecture.
Any questions about that? Then I'm going
to Next step is to talk about equity.
No?
Yeah.
Why don't we add the interest the risk
to the interest rate for the one year
now?
Well, because next year that one for
this particular bond
that that bond will have no risk because
it will be one year to go
and at the end of that year you're going
to get the 100.
So, there's no risk that added. If it
was a three-year bond, then you would
have in two of those you would have risk
premium.
And but you wouldn't have it in the last
one because in the last one you don't
have the you're going to receive the
100.
If the bond could could could default
so because I'm only looking at price
risk in the bond.
Uh uh
if the bond could could default, then I
would add an extra
term there because it's the fall risk.
But but here I'm just looking at price
risk and I'm assuming the the unit of
time is one year. So, just one year
before it expires there's no more risk
because there's no price in between
and and you're going to receive a 100
uh uh
at the end of the year. In reality
time is continuous. So, so every second
there's a little bit of a risk. So, you
have a little bit of that risk all the
time except for the last second.
Uh but but
I'm looking at a simple example where
you know
things happen every one year. And
In the book I think they mess up
actually. They put the risk premium in
the wrong place. But
there was another question.
No?
Okay.
So
let's look at the stock prices now.
Uh
So, a stock price has two key
differences with respect to
um
Well, certainly there were but two that
I want to highlight.
The first is that they don't pay
coupons, fixed amount. They don't
promise you to pay, you know, $100 two
years from now or anything like that.
They pay dividends.
Okay?
They tell you we have a policy of paying
dividends and even different companies
differentiate themselves by how much
they promise to give you on average in
dividends, but it's a promise that if
everything goes as planned, they'll pay
you those dividends.
It's not a commitment to pay you a
dividend. When it's very different from
a bond. A bond says, "I'll pay you a
coupon of this amount every six months."
And if you don't pay that coupon, that's
a default.
There's nothing like that in equity.
Equity you buy shares of Apple and you
sort of look at the history of dividend,
what what the CEO told you the last time
the in the last release uh and and and
you know, you you can you you think,
"Okay, these are more or less going to
be my dividends." But there's no
commitment.
They will always tell you
what's their plan
but it's a plan. It's not a commitment.
So, that's the first thing. It doesn't
have fixed coupons or anything like
that. There's no commitment. And in that
sense there's no sense of default
because there was no commitment, so
there's no default.
Uh if if a company has to cut dividends
to zero, that's not a default.
That's
conditions change. That's it. There was
no commitment to that.
The second
feature is that they don't have a fixed
terminal date.
99.9999999%
of the bonds do have a terminal date.
They have a maturity. I mean, there's a
few exceptions which are called
perpetuities.
That I think the US has none for
example. But but but but most bonds have
a
uh uh a a maturity.
Okay?
Equity doesn't come that way. Nobody
tells you buy a share of Apple you don't
buy shares of Apple that
they will that will be retired 30 years
from now. Okay?
They will be there as long as Apple's
exist.
Okay?
Uh
Now, of course, you know, if you had
shares of First Republic Bank, you have
nothing now.
And because of that but but that was not
the original plan. If First Republic
Bank had been successful, you would have
the the shares would have survived for a
very long period of time. Okay?
So so there's no sense of maturity. In
principle
equity can last forever.
Okay?
So, I'm going to use arbitrage to to to
price equity.
So
uh
let me So, let's we have the following
uh
portfolio of options here.
Uh
one is our old one-year bond.
Okay? So, you can invest your dollar
today in a one-year bond.
The alternative I'm going to say there
is some equity out there. And I'm going
to call the price of that equity Q
and the dividend of that e- e-
equity D. Okay?
So
so let's price this stock by by
arbitrage. So
equity is risky.
I mean, that is much riskier than than
than than bonds unless you are into
Argentinian bonds or things like that.
But I mean, it's much riskier than
bonds.
So, there's always a risk premium and
actually that itself is a trade. You
trade the risk premium of equity market.
So, I'm going to put an XS here. So what
do you what do you expect to get from
from holding
Remember, arbitrage means the same
holding period. So, I'm going to compare
investing in a one-year safe bond
versus
buying equity today, buying a stock
holding it for a year
and then selling it there.
Okay? That because that's That's I
cannot do arbitrage for paying different
holding periods. That's a one-year
holding period.
So, I'm saying this is what I'm going to
get from the bond. I'm going to require
some risk compensation for that because
risk equity is risky. So, I'm going to
want that. And this is what I'm going to
get That's my return on equity I get.
This is what I'm going to pay today for
the stock
say for a share of Apple
and I'm going to get this. This is the
dividend I expect to get
at the end of the year
and then I this is the price at which I
expect to sell
that share
one year from now.
Okay?
So, that's the return I'm expecting to
get from holding the share of Apple for
one period.
Okay?
And that's what I need to compare with
holding for one year
one-year bond. But I want also to be
compensated uh
for uh
risk. Okay?
Good.
Is this clear?
Okay,
good.
I don't know whether silence means yes
or no. But this is
No, we did something like this with the
two-year bond except that we didn't have
a a dividend there, you know,
because there was no coupon at day one.
We only had a final payment of 100. But
we did this already when we compare the
one-year bond with holding the two-year
bond for one period. We had exactly that
except that there was the expected
dividend there was zero because there
was no payment at the intermediate date.
Okay?
Good. So, we we know this concept
already. The only difference here is
again that there is expected dividend
and second that we have a risk premium
here which we added for bonds, but for
equity as I said it's typically much
larger than for bonds, especially if
you're talking about treasury bonds.
So, I'm going to reorganize this to
solve out for the price, this QT here.
That's what I want to figure out. What
is the price of the share of Apple?
Okay?
Well
I can reorganize this which means, you
know, move
dollar QT to the left, divide these two
guys here by 1 + I1T + XS and I get
this. Okay?
So, the price is equal to
the discounted
expected dividend. I have to discount it
because I expect to receive it one year
from now and I want I also compensation
for risk
plus the discounted value of the
money I'm going to get from from selling
the share of Apple one year from now.
Okay? Which I also discount
by the interest rate, but also with a
risk premium because that's a risky
investment.
Okay?
So, that's what we have.
Now
notice that
at T + 1
I will have an expression like that as
well.
Okay, again.
When we did the two-year bond
we didn't have an expression like that
because
after after one year the two-year bond
was going to be a one-year bond.
And so, we didn't need to think of put a
price there. We just put the 100. Okay?
Here is different because we said this
equity never expires unless the company
goes bankrupt, it's there.
So, in the next date I'm going to have
an expression exactly like that. I'm
just going to have an expected T +
dividend at T + 2 and expected price at
T + 2. Okay? And so on and so forth.
That means
I can replace this expression here
by an expression like this shifted all
by one year.
Okay? And I keep can keep doing that.
Then if I do that, I'm going to get then
two expected dividends here and then I'm
going to get a
uh So, I'm going to get
something like this but shifted by one
year and discounted by two terms in the
denominator, and then I'm going to get a
expected Q QT + 2.
Around here, okay?
Well, I can do a substitution of that as
well. Again,
okay? By everything shifted by two
years, and so on.
So, I can keep going.
And I can keep going, and going, and
going, and going on forever.
Okay?
So, if you keep doing it,
you're going to end up with an
expression that gives you the price of
the asset as expected this
present discounted value of all the
future dividends you expect.
Okay?
You see? I I'm summing
the T + 2, 3, 4, 5, and doesn't stop
here.
If I stop here, I'm going to have here a
you know, a Q
E T + N
+ 1.
Well, I can replace that thing again,
and I can keep going, keep going
forever.
Okay? So, you're going to integrate the
expected dividends, discounted dividends
to infinity.
Now, each future dividend is discounted
more and more heavily because the
denominator is growing, and growing, and
growing, because it's further out in the
future, it's worth less and less. Okay?
But, still it can go on forever.
And in fact, even if you if you
substitute this stuff a million times,
there's going to still be a little price
at the very end floating around.
Discounted, but it will never go away.
Okay? So, it never ends. There's no
maturity.
They keep going.
Now, I did everything up to now for
nominal in nominal terms. You can do
And that's the reason I
didn't want to spend much time with
this. You can do everything in real
terms as well.
Uh
and and and all all that happens here is
just remove the dollars, and just be
careful to replace uh
the nominal interest rate by the real
interest rate, but nothing deep there.
Okay? I can you can go to real pricing,
nominal pricing, and so on.
Okay? But, the the important concept is
not that. It is is the fact that
this that the the in principle we call
that, by the way, the fundamental value
of a of a of a of equity or of stock is
the expected present discounted value of
all the dividends. And you have to
discount it by the proper discounting
factor, which includes interest rate and
risk premium. But, that's what we call
typically fundamentals. We differentiate
that from what we call sometimes, I'm
going to show you an example later on,
bubbles.
When when the price seems to exceed
any reasonable sense of fundamentals.
Okay?
Okay, good.
Okay, let me sort of start
going back to to things that that um
we worry about in this course, and in
fact is a big issue. I don't know what
is happening to markets now. The what
the Fed did was very anticipated, but
but
um
but markets of often find a way to react
to things even if things were
anticipated, but
What happens? So, let me ask you a
following question.
What is the effect What do you think is
the effect
of an expansionary monetary policy
on the asset prices we have discussed?
So, bonds and equity.
Let's start with bonds
first.
What do you think is the effect of an
expansionary monetary policy? That means
a reduction in the interest rate on the
price of your 1-year bond, 2-year bond,
any any year you pick.
We already talked about that earlier.
Goes up.
The price of a bond is inversely related
to
the interest rate because if I cut an
interest rate,
means
a bond is something that pays the payoff
is in the future.
That thing in the future is worth more
if the interest rate goes down.
There's less discounting of it.
So, the price of the bond, any bond
here, will go up. The 1-year, 2-year,
3-year, 5-year, all of them.
They'll go up. Okay?
Assuming that nothing changes as a
result of the monetary policy. Look,
what happens is sometimes,
you know, markets think, "Oops, the Fed
messed up." And that leads to lots of
changes in all the term structure and
things like that because
they expect the market to react in a
strange ways to to this mistake made by
the Fed. But, here I'm saying suppose
that the Fed just cuts the interest rate
once, and everyone believes that the Fed
will continue to do so, and so on.
Well, then you're going to get uh that
that the price of bonds will go up.
What will happen to the price of stocks?
You want to answer.
Up.
But, it's
Well, but it's important to see that it
will go up probably for two reasons.
The first one
is that that
um
is that
it's also the case that a lot of the
price of an equity, actually even more
so than a bond,
has to do with expected payoffs in the
future.
So, if I lower interest rate, just the
effect of discounting will tend to raise
the price of So, even if I don't change
the expected dividends at all,
the fact that the interest rate goes
down,
for the same reason that the price of a
bond went up, the price of equity will
tend to go up. Okay? So, that's exactly
is the same logic.
But, there's an extra kick here for
equity, which is what?
That bonds did not have,
but equity does.
At least if it is an equity that is
positively related to aggregate
activity, but that's what I'm assuming
here.
Well,
yeah, that's the logic, no? Here, the
expansionary monetary policy is cutting
interest rate, but as a result of that,
output is going up.
When output is going up, sales will go
up, revenues will go up, dividends will
probably go up as well.
So, monetary policy can have very large
effect. I mean,
people in financial markets are looking
at the Fed all the time because it can
have a big impact on the price of those
assets.
An equity in particular can can be very
strong. And in fact, that's one of the
ways monetary policy works.
You know, when when when
the Fed cuts interest rates,
inflate it inflates the value of asset
prices, and that creates more wealth,
people feel richer, consume more, blah
blah blah. Firms feel also richer, they
invest more, and so on. That's That's it
That's
That's deliberate in a sense. Okay?
Uh that's one of the main mechanisms
through which monetary policy affects
aggregate demand. Just creates wealth.
And when there's too much demand too
much aggregate demand, like last like is
going on now, that's the reason we have
inflation, and so on.
You know, in 2022, the Fed went out and
deliberately destroyed wealth.
Because that's what that's what needed
to. Raise interest rate a lot, the price
of equity came down, even houses began
to bubble. Okay? The price of
uh of of treasury bonds also collapsed,
and so on and so forth. Okay?
Good.
Another experiment that we did sort of
early on, lecture three, four, but
around there,
is
What happens What do you think happens
when there's an increase in consumer
spending?
So, suppose that now, remember we had a
a C 0 floating around, an autonomous
consumption component, and so suppose
that that goes up.
What do you think happens to asset
prices?
And this is a big issue these days,
actually.
Exactly. That's right. That's That's
That's very good. It depends a lot. I
mean, when financial markets receive
news every day, there are releases of
news and of all sort of things. Okay?
And and
in financial markets, they people always
think, "Okay, this is the news.
The obvious thing for this is
you know, good news, because this will
tend to increase output. Output will
increase dividends. That's a good good
thing for
for stocks."
Uh
But, the immediate reaction is, "Whoa,
but what will the Fed do about this?
Does the Fed like
that we have more aggregate demand or
not?"
Okay?
And so so so that's that's
key here.
And and uh so suppose that in this case,
the Fed did not like
the Fed like today to the Fed doesn't
want more aggregate demand today.
There's no central bank around the
world, maybe in China, but but there's
no other central bank around the world
that wants more aggregate demand.
Okay?
So, so if if it's if if you the release
is consumer
are very bullish now,
uh
that's not good news. I mean, financial
markets immediately say, "Uh-oh, we have
a Fed that is watching for inflation.
This means they're going to hike
interest rates."
Okay?
So, what happens to the price of bonds
then in this environment when C 0 goes
up, and the Fed doesn't like it? And and
the markets know that the Fed doesn't
like it. The Fed may take a month to
react to it, but markets react
immediately, say, "Whoa, this is what
the Fed will do 1 month from now."
Okay?
So, what do you think happens to the
price of bonds
if we get news that, you know, consumers
are
very bullish, and and and and it turns
out that we also have
of you know 4% or so, so we know that
the Fed doesn't like more aggregate
demand.
What do you think will happen to the
price of bonds?
Well,
again,
the news happens say
uh
a week ago
and the Fed moves one week later.
So so markets are going to anticipate
that in this case the Fed will hike
interest rates.
If the Fed is the markets anticipate
that the Fed will hike interest rate,
interest rate will go up immediately.
Not the not the rate that the Fed
controls, but the one-year rate, the
two-year rate, the three-month rate, all
those rates are going to go up
immediately as a result of that.
Okay? And that
we know
reduces the price of bonds. Bonds and
interest rates are The price of a bond
and the interest rates are inversely
related. So the anticipation that the
Fed will hike rate will lead to higher
interest rates at all horizons and and
and that will reduce the price of bonds.
Okay? So this thing that and for equity,
well, look what happened for equity
here. Well, for equity you say, "Okay,
well, I get the same discounting effect
of the bond, which is bad news, goes
down."
And
and what about The good news is the
dividend, no? Because now I have more
consumers.
Well, that depends on how much the Fed
dislikes this stuff because if the Fed
does this, that mean it offsets it fully
offsets
the the effect on aggregate demand.
Increasing this zero shift IS to the
right, that would have increased output
to here. The Fed doesn't want more
output, so we will hike interest rate up
to the point in which output doesn't go
up.
That means dividends are not going to go
up either.
So we get just a negative effect of the
discounting and we don't get the benefit
of the extra activity that would have
come from having consumers that are more
optimistic and so on. Okay?
So this is actually this has happened a
lot
uh
over the last few months.
This is an environment people call it's
an environment where good news is bad
news.
Okay?
Good news about aggregate demand,
consumers are happy, blah blah blah, is
bad news or labor markets are very
tight, wages are going up.
All things that sound wonderful in other
environments
sound terrible news for the financial
markets. Okay?
For most, I mean there's difference in
different sectors and so on, but but for
the aggregate, for the average,
it's bad news. So this is an environment
where good news is bad news. Good news
about aggregate demand, you have to be
specific about what. Good news about
aggregate demand is bad news
for asset markets.
It's not always like that.
If you're in a recession,
the Fed doesn't want to fight that. It
wants to have more aggregate demand. So
if you get good news about aggregate
demand, that's very good news for asset
prices
because the Fed will not offset that and
you get the positive effect of the extra
dividends and things like that. Okay?
So
Okay.
Another component that is that moves
asset prices a lot. So monetary policy
moves asset prices a lot. Okay? And and
monetary but monetary policy doesn't
happen in
some separate isolated space. It it it
reacts to news about the economy, about
consumers, about firms, about regional
banks, all sort of things. Okay?
Uh another big driver of asset prices is
this guy here
of of equity in particular
is this risk premium.
Okay?
So that risk premium can move a lot
and and it's an important driver of
asset prices.
This index, this is the it's called VIX.
VIX is I'm not going to explain what it
is, but
people call it so you get a the picture,
an index of fear in an equity market. It
it it's it's done
Well, I'm not going to tell you what it
is. It's it's based on option prices and
so on.
Uh so this is
this is, you know, when people realize
that COVID
was coming and so what you see is that
this thing exploded up.
Big big risk off.
That's a massive spike in the little
excess.
Well, not surprisingly look what
happened to equity.
You know, collapsed by 35% or so.
Part of that was expected dividends,
blah blah blah,
but a lot of it was the risk off.
And it's called risk off when
markets are very fearful. They don't
want to take risks, risk off. Okay? Uh
the recovery actually also had a lot to
do with
the recovery on the risk environment.
People were sort of
getting used to the thing.
But that recovery also was a result of
very aggressive monetary policy. The Fed
tried to offset this by it cutting
interest rates very aggressively and
that also gave a boost to asset prices.
In fact, they did so much that we ended
up with a big
lots of overvaluation in asset prices
and then that's the reason when they
hiked rates, so we had big a big decline
in asset prices
as a result. Okay?
What is this? Ah, look, this is
you know
over the weekend
over the weekend the
I I
we talked about this in the previous
lecture
um essentially the First Republic Bank
went under
uh and JP Morgan absorbed it.
Uh so people thought that um
that on Monday was was good because you
know, people thought that
this mini crisis was over.
Well, yesterday
uh it turns out that that
two other regional banks, their shares
began to collapse in the same way as the
First Republic Bank shares
collapsed the week before. Okay? So
panic immediately set in. So the VIX,
the fear index
This is intraday. So markets open here
and and the shares of this this this two
banks began to decline very rapidly
and so
VIX went up a lot.
And what you do This is SP This is the
main This is the SPX, the the main SP
S&P 500. It's the main price index
equity price index in the US
immediately declined.
Okay? So it's a That's the excess
moving.
Here excess move up
little X
and then it began to come down and the
markets began to recover.
So this risk on and off is a is a very
big driver
of equity prices.
This is one of the banks actually
that was in trouble.
Uh
You you see that
but by the end of the day this this this
this is
PacWest. PacWest had the decline by 28%
by the end of the day. But you see
things look very weird here. They don't
look like normal prices.
Okay? Here they look like normal prices.
They're moving all the time.
Here they don't.
What happens is that these prices
decline so rapidly that they they
trigger what is called circuit breakers.
So the
you cannot trade those those shares when
they decline too rapidly. And that's
done deliberately so this little X
doesn't get completely out of control.
People to calm down. Okay?
And so it triggered several times.
Just as
the the whole idea is that people calm
down.
Is there a question? Yeah, there's some
of us like
The previous or this one? Yeah, the
previous one.
Is
Are either of them dependent on the
other or are they more just showing the
same sort of trend? No, no. Okay, it it
doesn't a good question. Uh uh
This is the risk component only. So this
is more independent what I'm saying.
When this guy goes up, if nothing else
happens,
uh this will decline because you're
discounting things more heavily.
But it is true that there were some
common elements. Like there there are
also common elements, which is people
got very worried about having another
regional bank collapsing and so on. And
so that that also created fear about the
economy, which is an independent reason
for this to decline. And normally in
recessions as well, this risk in
appetite is is is is lower. So so you're
right that it's a common component. But
the point I was highlighting is that
is that this VIX sort of is a big
driver. It has a big impact on asset
prices.
But it's not the cause.
It was an event that caused both, but
the fact that this event came with this
biggest spike in in the VIX meant that
that the impact on the equity index was
was larger than if it had been only news
about the economy, meaning that there
was a recession ahead or something like
that.
And let me just finish with a with with
the opposite phenomenon.
You know,
I was talking in episodes of fear, but
sometimes markets get very carried away
in the opposite direction. Okay? And
here I'm showing you you know, examples.
I put together this picture many years
back and now Deutsche Bank keeps
updating it, which is it shows you some
some It seems that the world needs a
bubble somewhere.
And then here it shows you several sort
of big asset valuations, you know, look
500%.
This here is the Nikkei. I mean, it was
enormous appreciation of the Nikkei.
Here was Bitcoin. Then it collapsed.
Okay? They always end up bad. When you
never you see this big sort of a spiking
up, they almost always end up quite
poorly. Now, this is
is much more likely that it happens in
equity than in bonds. In bonds, it
cannot happen because there is a
terminal date,
a terminal value. So, so what happens
with these kind of things, people dream
that the value go will go to infinity.
No, and it could because the thing will
last to infinity and and you know, the
price could go to infinity. For a bond,
that cannot happen because it has a
terminal date and at that date they're
going to pay you 100, so it can't
happen.
But for equity, people's imagination can
run very wild. In fact, there is a
famous bubble, the South Sea Bubble.
It's a company in the UK.
It is a famous for many reasons, but but
one of them is that Isaac Newton got
involved in in this one. And and you
know,
he got carried away. He he sold, he made
a profit, you know, he sold the shares
at 7,000. He profited 3,500 pounds,
which must have been an enormous amount
of money at the time.
Prices kept going up,
couldn't resist, went back in, ended up
losing 20,000 pounds, which must have
been a lot of money. So, he famously
said, "I can calculate the motions of
the heavenly bodies, but not the madness
of people." It's all about expectations,
okay?
Let me stop here.