Economics for Financial Markets.pdf

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PrefaceThisbookisaboutwhataspectsofeconomicsitisnecessarytoknowabouttounderstandwhyfinancialmarketsaresovolatile.Itisdesignedtodemonstratethatbehindallthejargonassociatedwiththefinancialmarketstherearesomebasiceconomicideasoperating.Whatthesebasicideasareisnotevidentfromeitherexistingtextbooksnorfromreadingthefinancialpress.Thetextisnotdesignedasastandardeconomicstextbookasthemarketplaceisfullofexcellenttextbooksforanyoneseekingtounderstandbasiceconomicideas.Priortothepublicationofthistextreadersseekingtounderstandhowtheeconomicsworldandtherealfinancialmarketplaceinteracthavehadaproblem.Thefinancialmarketsareunundatedwithinformation.Fromallthisinfor-mationhowcanonemakesenseofthistoseethebigfinancialmarketpicture?Certainlynotbyreadingstandardeconomicstextbooks.Thetextisdesignedforabroadreadershipincludingstu-dents,bothundergraduateorpostgraduatemajoringineco-nomicsoffinance,practitionersinthemarketsseekingafreshinsightintowhatisgoingonaroundthemeveryday,andfornewcomerstothefinancialmarketswhoneedaclearperspec-tiveonallthedailyupsanddownsinthemarkets.Torepeat,theseobjectivesarenotachievedbyreadingtheexistingliterature.ThetexttakestheUSeconomyasitsframeofreference.ThisisbasedonthefactthatthesheersizeoftheUSeconomyintheworldfinancialmarketsissolargethatitdwarfsmostotherfinancialmarketplaces.AlsothedominationoftheUSdollarastheworld’sglobalcurrencymeansthatwhatmovesthedollar xiiPrefacebasicallymovesalltheotherfinancialmarkets,andclearlywhatevercanmovethevalueofthedollarhastobeunderstood.Howeverthetextisjustasrelevanttoreadersoperatinginotherfinancialmarkets,asoncetheyunderstandtheeconomicimplicationsofchangesintheUSfinancialmarketplacetheycaneasilyseetheimplicationsfortheirowndomesticeconomy. 1Whatdoyouneedtoknowaboutmacroeconomicstomakesenseoffinancialmarketvolatility?Inordertoappreciatetheimpactofeconomicactivityonthefinancialmarketsitisessentialtofirstappreciatewhatarethemajorconstituentitemsthatdrivetheeconomy.Theseitemsarebestunderstoodbyexaminingwhatisreferredtoasthestandardmacroeconomicmodel.Macroeconomicsconcentratesonthebehaviourofentireeconomies.Ratherthanlookingatthepriceandoutputdecisionsofasinglecompany,macroeconomistsstudyoveralleconomicactivity,theunemploymentrate,thepricelevel,andotherbroadeconomiccategories.Thesearereferredtoaseconomicaggregates.An‘economicaggregate’isnothingbutanabstractionthatpeoplefindconvenientindescribingsomesalientfeatureofeconomiclife.Amongthemostimportantoftheseabstractnotionsistheconceptofnationalproduct,whichrepresentsthetotalproductionofanation’seconomy.Theprocessbywhichrealobjects,suchascars,ticketstofootballmatchesandlaptopcomputers,getcombinedintoanabstrac-tioncalledthenationalproductisoneofthefoundationsofmacroeconomics.Wecanillustratethisbyasimpleexample.ImagineanationcalledTitanicawhoseeconomyisfarsimplerthanthemoredevelopedeconomiesoftheWest.BusinessfirmsinTitanicaproducenothingbutfoodtoselltoconsumers.Ratherthandealseparatelywithallthemarketsforhamburgers,icecream,automobilesandsoon,macroeconomistsgroupthem 2EconomicsforFinancialMarketsallintoasingleabstract‘marketforoutput’.ThuswhenmacroeconomistsinTitanicaannouncethatoutputinTitanicarose10percentthisyear,aretheyreferringtomorepotatoes,hamburgersoronions?Theansweris:Theydonotcare.Theysimplyaggregatethemalltogether.Duringeconomicfluctuations,marketstendtomoveinunison.Whendemandintheeconomyrises,thereismoredemandforpotatoesandtomatoes,moredemandforarti-chokesandapples,moredemandforspaghettiandpizzas.Andviceversawhentheeconomyslowsdown.Thereareseveralwaystomeasuretheeconomy’stotaloutput,themostpopularbeingthegrossnationalproduct,orGNPforshort.TheGNPisthemostcomprehensivemeasureoftheoutputofallthefactories,officesandshopsintheeconomy.Specificallyitisthesumofthemoneyvaluesofallfinalgoodsandservicesproducedwithintheyear.ThisisoftenreferredtoasnominalGNP.Aggregatedemandwithintheeconomy,anotherapplicationoftheaggregationprinciple,referstothetotalamountthatallconsumers,businessfirms,governmentagencies,andforeign-erswishtospendonalldomesticallyproducedgoodsandservices.Thelevelofaggregatedemanddependsonavarietyoffactors,forexample,consumerincomes,thepricelevel,govern-menteconomicpolicies,andeventsinforeigncountries.ThebigpictureThenatureofaggregatedemandcanbeunderstoodbestifwebreakitupintoitsmajorcomponents.TheseareConsumerExpenditure(C),InvestmentSpending(I),GovernmentSpend-ing(G),andthelevelofExports(X)minusthelevelofImports(M).Thisgivesusthefollowingfamiliarrelationship:AggregateDemand(GNP)=C+I+G+(X–M)ConsumerExpenditure(C)isthetotalamountspentbyconsumersonnewlyproducedgoodsandservices(excludingpurchasesofnewhomes,whichareconsideredinvestmentgoods).InvestmentExpenditure(I)isthesumoftheexpenditureofbusinessfirmsonnewplantandequipment,plustheexpendituresofhouseholdsonnewhomes.Financial‘invest-ments’,suchasbondsorstocks,arenotincludedinthiscategory. Whatdoyouneedtoknowaboutmacroeconomicstointerpretfinancialmarketvolatility?3GovernmentSpendingreferstoallthegoods(suchasaeroplanesandpencils)andservices(suchasschoolteach-ingandpoliceprotection)purchasedbyalllevelsofgovern-ment.Itdoesnotincludegovernmenttransferpayments,suchassocialsecurityandunemploymentbenefits.Netexports(X–M)isthedifferencebetweenexports(X)andimports(M).Itindicatesthedifferencebetweenwhatacountrysellsabroadandwhatitbuysfromabroad.NationalIncomeisthesumoftheincomesofalltheindividualsintheeconomy,earnedintheformofwages,interest,rents,andprofits.Itexcludestransferpaymentsandiscalculatedbeforeanydeductionsaretakenforincometaxes.DisposableIncome(DI)isthesumoftheincomesofalltheindividualsintheeconomyaftertaxeshavebeendeductedandalltransferpaymentshavebeenadded.Havingintroducedtheconceptsofnationalproduct,aggregatedemandandnationalincomewemustillustratehowtheyinteractinthemarketeconomy.WecanbestdothiswithreferencetoFigure1.1,whichisnotascomplexasitmayinitiallyappear.Figure1.1iscalledacircularflowdiagram.Itdepictsalargecirculartubeinwhichafluidiscirculatinginaclockwisedirection.ThereareseveralbreaksinthetubewhereeitherRestofExpenditurestheworldC+I)(C)23(M)nC(Xo+tsFinancialsystempti)IortsI)(G+prm(oSutsGpasneImxvnesEaionmhCtgrcsseu4(vpSntCIn)+eIInvestorsm+nrGe+Consumersv1oXG-MDGovernmentisposTFirms(producethearaTba5lennationalproduct)xinsecfoesmre(Ds6meI)lincoNationaIncomeFigure1.1Thecircularflowofexpenditureandincome(adaptedfromBaumolandBlinder:Economics). 4EconomicsforFinancialMarketssomeofthefluidleaksout,oradditionalfluidisinjectedin.Atpoint1onthecirclethereareconsumers.DisposableIncome(DI)flowsintothem,andtwothingsflowout:consumption(C),whichstaysinthecircularflow,andsavings(S),which‘leakout’.Thisjustmeansthatconsumersnormallyspendlessthantheyearnandsavethebalance.This‘leakage’tosavingsdoesnotdisappear,ofcourse,butflowsintothefinancialsystem.Theupperloopofthecircularflowrepresentsexpenditure,andaswemoveclockwisetopoint2,weencounterthefirst‘injection’intotheflow:investmentspending(I).Thediagramshowsthisascomingfrom‘investors’–agroupthatincludesbothbusinessfirmsinvestingforfutureproductionandcon-sumerswhobuynewhomes.Asthecircularflowmovesbeyondpoint2,itisbiggerthanitwasbefore.TotalspendinghasincreasedfromCtoC+I.Atpoint3thereisyetanotherinjection.Thegovernmentaddsitsdemandforgoodsandservices(G)tothoseofconsumersandinvestors(C+I).NowaggregatedemandisuptoC+I+G.Thefinalleakageandinjectionscomesatpoint4.Hereweseeexportspendingcomingintothecircularflowfromabroadandimportspendingleakingout.Theneteffectofthesetwoforces,i.e.,netexports,mayincreaseordecreasethecircularflow.Ineithercase,bythetimewepasspoint4wehaveaccumulatedthefullamountofaggregatedemand,C+I+G+(X–M).Thecircularflowdiagramshowsthisaggregatedemandforgoodsandservicesarrivingatthebusinessfirms,whicharelocatedatpoint5atthesouth-eastportionofthediagram.Respondingtothisdemand,firmsproducethenationalprod-uct.Asthecircularflowemergesfromthefirmswehaverenameditnationalincome.Nationalproductisthesumofthemoneyvaluesofallthefinalgoodsandservicesprovidedbytheeconomyduringaspecifiedperiodoftime,usuallyoneyear.Nationalincomeandnationalproductmustbeequal.Whyisthisthecase?Whenafirmproducesandsells$100worthofoutput,itpaysmostoftheproceedstoitsworkers,topeoplewhohavelentitmoney,andtothelandlordwhoownsthepropertyonwhichthefirmislocated.Allofthesepaymentsareincometosomeindividuals.Butwhatabouttherest?Suppose,forexample,thatthewages,interest,andrentthatthefirmpaysaddupto$90,whileitsoutputis$100.Whathappenstotheremaining$10?Theansweristhattheownersofthefirmreceiveitasprofits.Buttheseownersarealsocitizensofthecountry,sotheirincomesalsocountinthenationalincome.Thus,whenweaddupallthewages,interest,rents,andprofits Whatdoyouneedtoknowaboutmacroeconomicstointerpretfinancialmarketvolatility?5intheeconomytoobtainthenationalincome,wemustarriveatthevalueofthenationaloutput.Thelowerloopofthecircularflowdiagramtracestheflowofincomebyshowingnationalincomeleavingthefirmsandheadingforconsumers.Butthereisadetouralongtheway.Atpoint6,thegovernmentdoestwothings.First,itsiphonsoffaportionofthenationalincomeintheformoftaxes.Second,itaddsbackgovernmenttransferpayments,suchasunemploy-mentpayandsocialsecuritybenefits,whicharesumsofmoneythatcertainindividualsreceiveasoutrightgrantsfromthegovernmentratherthanaspaymentsforservicesrenderedtoemployers.WhentaxesaresubtractedfromGNP,andtransferpaymentsareadded,weobtaindisposableincome.DI=GNP–Taxes+TransferPayments.Disposableincomeflowsunimpededtoconsumersatpoint1,andthecyclerepeats.FinancialmarketsandtheeconomyNowthatwehaveanappreciationofhowtheeconomyworkswemustexaminehowthefinancialmarketsinterrelatetotherealeconomy.IntryingtoassessthesignificanceofaneconomicindicatortothefinancialmarketsitisimperativetounderstandthateachparticularindicatorprovidesapieceofinformationaboutsomeaspectofnominalGNP.EconomicanalystsareconcernedaboutnominalGNPbecausethereisarelationshipbetweennominalGNPandmoneygrowth.ThisrelationshipcomesaboutbecauseasnominalGNPacceleratesthereisincreaseddemandfortransactionsbalances,themoneyweholdtospendlater.Notsurprisingly,therefore,thegrowthrateandnominalGNParerelated.WhatisimportanthereisthatthereisanidentifiablerelationshipbetweenthegrowthratesofnominalGNPandthevariousmonetaryaggregates.Becauseofthislong-standinghistoricalrelationship,theUSFederalReserve(theUScentralbank)hasadoptedspecificgrowthratetargetsforseveralofthemonetaryaggregates.Therefore,ifsomethingcausesnominalGNPtogrowmorequickly,thenitwilltranslatealmostassuredlyintomorerapidgrowthofthemoneysupply.Ifmoneysupplygrowthpicksup,theFederalReserveislikelytorespond 6EconomicsforFinancialMarketsbytighteningitsgriponmonetarypolicy.Itdoesthisbyraisinginterestrates.Asinterestratesrisethepriceoffixedincomesecuritiesdeclines.ThisisdiscussedinChapter2,andlaterinthebook,butasanexample,considerasituationinwhichsomebodyholdsaTreasurybondthatyields10percent.IftheeconomyexpandsrapidlyandtheFederalReserveiseventuallyforcedtotightensothatbondratesriseto12percent,the10percentbondbecomeslessattractiveanditspricedeclines.Investorswouldratherownthehigheryielding12percentsecurity,andtheywouldthereforeselltheloweryieldingassetdrivingdownitspriceandforcingupitsyield.Thus,anythingthatcausesnominalGNPtoriseincreasesthelikelihoodthattheFederalReservewilltightenbyraisinginterestrates,whichinturncausesbondpricestodecline.ItisalsoimportanttorecognizethatnominalGNPconsistsoftwoparts:real(orinflation-adjusted)GNP;andtheinflationrate,whichismeasuredbytheGNPdeflator,definedfurtherinChapter4.Whenwereferspecificallytogrowthrates,thegrowthrateofnominalGNPequalsthesumofthegrowthratesofrealGNPandtheinflationrate.Thus,8percentnominalGNPgrowthmightconsistof4percentrealGNPgrowthand4percentinflation,or2percentrealGNPgrowthand6percentinflation.Fromthemarket’spointofview,anythingthatresultsineithermorerapidGNPgrowthorahigherrateofinflationwillcausenominalGNPtogrowmorerapidly.Asnotedearlier,thiscausesmoneygrowthtoaccelerate,increasesthelikelihoodofaFederalReservetighteningmove,andimplieshigherinterestratesandlowersecuritiesprices.Conversely,lowerGNPgrowthandlowerinflationimplyslowerGNPgrowth,whichcouldcausetheFederalReservetoease.AFederalReserveeasingmovewouldbringaboutlowerinterestratesandhighersecuritiesprices.Whileitmayseemsomewhatunsavoury,thefactofthematteristhatthefixedincomemarketsthrivewhentheeconomycollapsesandmovesintoarecession,andtheysufferwhentheeconomyisdoingwellandexpandingrapidly.Therefore,wheninterpretinganeconomicindicatoritiscriticaltodeterminetheeffectthataparticularindicatorwillhaveoneitherGNPgrowthorontheinflationrate.ItisusefultocarrythebreakdownofrealGNPonestepfurtherinordertofocusonspecificsectorsoftheeconomythatcanattimesmoveinseveraldifferentdirections.Aswediscussedearlier,realGNPconsistsofthesumofconsumptionexpendi-tures(C),investmentspending(I),governmentexpenditures(G) Whatdoyouneedtoknowaboutmacroeconomicstointerpretfinancialmarketvolatility?7andnetexports(orexports–imports)(X–M).ThisequationisfrequentlyreferredtoasGNP=C+I+G+(X–M).Ifoneislookingataneconomicindicatorthatreferstotherealeconomy,itisextremelyhelpfultobeabletoidentifytheparticularcomponentofGNPthatitaffects.Forexample,whenretailsalesarereleasedoneshouldimmediatelyrecognizethatretailsalesprovideinformationaboutconsumerspending,whichinturnhasimplicationsfortheconsumptioncomponentofGNP.Then,havingdeterminedtheeffectonGNP,onecansaysomethingaboutthelikelihoodofachangeinFedpolicy.InChapters4,5and6wedescribeindetailthewayanexperiencedeconomicanalystwouldusetheplethoraofdataontheUSEconomytogainafeelfortheprospectsfortheeconomyandinturnthefinancialmarkets.HavingstressedtheimportanceofdetermininghowaneconomicindicatoraffectsnominalGNP,itisalsoimportanttobeawarethatitisnotsomuchtheabsolutechangeinanindicatorthatisimportant,buthowitcomparestomarketexpectations.Indeedthecriticaljudgementtobemadewhenanalysingmarketbehaviourisonwhatthefinancialmarketisexpectingandwhy.Infinancialmarketlanguage,thisiscalledknowingwhathasbeen‘discounted’bythemarket.Forexample,ifitiswidelybelievedthattheFederalReserveislikelytocuttheFedfundsrateoverthenextfewweeks,thenbondpriceswillreflectthatbelief.WhentheFedfundsrateisactuallycut,bondpricesmaynotmoveverymuch,becausetheexpectationthatwasdiscountedintothemarketwasactuallyrealized.Ontheotherhand,ifforsomereasontheFederalReservechoosesnottocuttheFedfundsrate,wheneveryonethoughtitwasgoingto,thenbondpricesmayreactquitenegatively,becausetheexpectationofaFedfundsratecutprovedtobeincorrect.Whatthisexampleshowsistheimportantfunctionthatexpectationsplayinthetimingofapricemovement.Majoreventsthatarewidelyanticipatedmayhaveabsolutelynoeffectonpricesatthetimetheyoccur.Other,equallymajor,eventscanhaveaprofoundimpactonpricesiftheywerenotanticipated.Thefirstlessonthenofmarketdynamicsandexpectationsisthatonemustknowwhatfutureeventshavealreadybeendiscountedbythefinancialmarkets.InChapters4,5and6webreakdownthecomponentsofGNPandanalysewhichregularlypublisheddatawillbestindicatethelikelyfuturetrendoftheUSeconomyandtheirlikelyimpactonfinancialmarkets.Wewillanalyseeconomicdatausingthe 8EconomicsforFinancialMarketsfollowingclassificationsystem,inorderthataconsistentanalyticalapproachcanbeapplied.TitleoftheIndicatorDefinitionWhopublishesitandwhen?Howdoyouinterpretit?Whatisitsimpactonfinancialmarkets?GrossnationalproductandgrossdomesticproductGrossdomesticproduct(GDP)measuresthetotalvalueofUSoutput.ItisthetotalofalleconomicactivityintheUS,regardlessofwhethertheownersofthemeansofproductionresideintheUS.Itis‘gross’becausethedepreciationofcapitalgoodsisnotdeducted.GDPismeasuredinbothcurrentprices,whichrepresentactualmarketprices,andconstantprices,whichmeasurechangesinvolume.Constantprice,orreal,GDPiscurrent-priceGDPadjustedforinflation.Thefinancialmarketsfocusontheseasonallyadjustedannualizedpercentagechangeinreal-expenditurebasedGDPinthecurrentquartercomparedtothepreviousquarter.ThedifferencebetweenGDPandgrossnationalproduct(GNP)isthatGNPincludesnetfactorincome,ornetearnings,fromabroad.ThisismadeupofthereturnonUSinvestmentabroad(profits,investmentincome,workers’remittances)minusthereturnonforeigninvestmentintheUS.Itisnational,becauseitbelongstoUSresidents,butnotdomestic,sinceitisnotderivedsolelyfromproductionintheUS.MonetarismandfinancialmarketsMonetaristviewsgainedwidespreadinfluenceintheUnitedStatesinthe1970s.TheseviewshavesincespreadtoEuropewiththeEuropeanCentralBanknowalsoapplyingmonetaristprinciplesinimplementingeconomicstabilizationpolicies. Whatdoyouneedtoknowaboutmacroeconomicstointerpretfinancialmarketvolatility?9Theriseofmonetarismasakeyanti-inflationpolicystartedinOctober1979whenthenewChairmanoftheFederalReserve,PaulVolcker,launchedafiercecounter-attackagainstinflationinwhathasbeencalledthemonetaristexperiment.InadramaticchangeofitsoperatingprocedurestheFederalReservedecidedtostopsmoothinginterestratesandinsteadfocusedonkeepingbankreservesandthemoneysupplyonpredeterminedgrowthpaths.TheFederalReservehopedthatastrictquantitativeapproachtomonetarymanagementwouldaccomplishtwothings.First,itwouldallowinterestratestorisesharplyenoughtobraketherapidlygrowingeconomy,raisingunemploymentandslowingwageandpricegrowththroughthePhillips-curvemechanism.Second,somebelievedthatatoughandcrediblemonetarypolicywoulddeflateinflationaryexpectations,particularlyinlabourcontracts,anddemonstratethatthehigh-inflationperiodwasover.Oncepeople’sexpectationsweredeflated,theeconomycouldexperiencearelativelypainlessreductionintheunderlyingrateofinflation.Themonetaristexperimentwaslargelysuccessfulinreducinginflation.Asaresultofthehighinterestratesinducedbyslowmoneygrowth,interest-sensitivespendingslowed.Conse-quentlyrealGNPstagnatedfrom1979to1982,andtheunemploymentraterosefromunder6percenttoapeakof10.5percentinlate1982.Inflationfellsharply.Anylingeringdoubtsabouttheeffectivenessofmonetarypolicywerestilledanditsinfluenceonpolicymakersremainsforefronttothisday.Thequantitytheoryofmoney–thebasisofmonetarism‘Monetarist’economistsemphasizethatthegovernment’smon-etarypolicy(i.e.,controllingthesupplyofmoneyintheeconomy)ismoreimportantforthemanagementoftheeconomythanfiscalpolicy(i.e.,governmentpolicyonspending,taxationandborrowing).Thefundamentalideabehind‘mone-tarism’isthatthereisacloselinkbetweentheamountofmoneyintheeconomyandthelevelofprices.Thisrelationshipisbaseduponthequantitytheoryofmoney.Misuseofthemoneysupplycanbeillustratedbytwospectacularlyunstableepisodesineconomichistory.One 10EconomicsforFinancialMarketsinvolvedtheinfamousGermaninflationintheyearsfollowingtheFirstWorldWar.InDecember1919,therewereabout50billionmarksincirculationinGermany.Fouryearslater,thisfigurehadrisentoalmost500000000000billionmarks–oranincreaseof10000000000times!Moneybecamepracticallyworthlessandpricessky-rocketed.Indeed,moneylostitsvaluesoquicklythatpeoplewereanxioustospendwhatevermoneytheyhadassoonaspossible,whiletheycouldstillbuysomethingwithit.ThesecondillustrationinvolvestheUnitedStatesexperienceintheDepressionofthe1930s.Economistsarestilldebatingtheexactcausesofthatdepressionandtheirrelativeimpor-tance.Butitcanscarcelybedeniedthatthemisbehaviourofthemonetaryandbankingsystemplayedarole.Astheeconomysliddownintothedepression,thequantityofmoneyfellfrom$26.2billioninmid1929to$19.2billioninmid1933–orby27percent.BythetimeFranklinD.RooseveltbecamePresidentin1933,manybankshadclosedtheirdoorsandmanydepositorshadlosteverything.Thequantitytheoryisessentiallyconcernedwiththedemandforastockofmoneyinone’sportfolio.Peoplewishtoholdmoneyprimarilytoeffecttransactionsingoods,services,andfinancialassets.Inamoderneconomywenormallyusethemediumofmoneybecauseitsavesustheextensivecostsofsearchandlengthyargumentsofbartertransactions.Butthisimpliesthat,toavoidbarter,wemustmaintainsomequantityofmoneyinourportfolio,sincesalesofgoodsandpurchasesarenotnicelymatchedwithoneanotherinanygivenperiodoftime.Thequantityofmoneywerequireinourportfoliowilldependonmanyfactors.Probablythemostimportantwillbethevalueoftransactionsconcludedduringagiventimeperiod.Otherthingsbeingequal,thehigherthevalueoftransactions,thelargerwillbethequantityofmoneyweshallwishtohold.Thevalueoftransactionsconsistsoftwoelements,priceandquantity;foragivenquantity,thehighertheprice,thelargertheamountofmoneyonewouldwishtohold(andviceversa).Eachofus,individually,makesadecisionaboutthequantityofmoneythatwewillholdinourportfolio.Eachpersonadjuststheirstockofmoneyaccordingtothevalueofthetransactions,whichtheywishorexpecttomakeduringtheensuingtimeperiod.Foranygivenvalueoftransactionsintheeconomytherefore,wecouldfindthetotaldemandformoneybysummingthedemandsofindividuals.Thisgivesustheaggregatedemandformoney. Whatdoyouneedtoknowaboutmacroeconomicstointerpretfinancialmarketvolatility?11Letusnowassumethattheaggregateamountofmoneydemandedisgreaterthanthesupplyofmoneythatthegovernmenthasmadeavailable(orprinted),i.e.,thereisanexcessdemandformoney.Usingelementaryeconomicanalysisonewouldpredictthatasindividualsdesiremoremoneyintheirportfoliosofwealththantheycurrentlyhave,theywouldachievethisbysellinggoodsinexchangeformoneyand/orforegobuyinggoods.Thiswillreducethedemandforgoodsandthepriceofgoodswillfall.Iftheproductionofphysicalgoodsdoesnotchangetheonlyeffectwillbeonthelevelofprices.Aspricesdiminishsowillthedemandformoney,asone’sneedfortransactionstobalanceisthatmuchlower.Thus,whenpriceshavebeenreducedsothatatthelowervalueoftransactionspeopleare,inaggregate,justwillingtoholdthesupplyofmoneymadeavailablebythegovernment,thepricereductionswillstop.Thenthedemandformoneywillbejustequaltothesupplyandthesystemisbackinequilibriumatalowerlevelofprices.Soifthedemandformoneyisgreaterthanthesupplyofmoneythereareforcesintheeconomywhichbringthetwobacktogether.Onemaytracetheeffectsofanexcesssupplyofmoneyinpreciselythesameway.Imaginethatthegovernmentprintssomeextradollarbillsanddistributesthemfreelytoeveryoneintheeconomy.Eachofuswouldthenfindthathehastoomuchmoneyinhisaccountrelativetothevalueofhistransactions.Consequently,hewouldreducehismoneystockbybuyinggoods.Thiswoulddriveupthepriceofgoods.Thus,thevalueoftransactionswouldincreaseuntilpeople’sdemandsformoneywereatsuchalevelthattheywouldbewillingtoholdtheincreasedstockofmoneyatthisnewhighlevelofprices.Againthereareforcesbringingthedemandfor,andsupplyof,moneybacktogether.Theseideasunderlinethesimplestversionofthequantitytheory.Toillustratethispointfurther,considerthefollowing.PQ=nationalincomemeasuredinmoneyterms,whereM=quantityofmoney,P=averagelevelofprices,andQ=quantityofoutput.Itisassumedherethatthequantityofoutputandthequantityofincomeareinterchangeabletermsonthegroundsthatoutput(i.e.producing)generatesincome.V=incomevelocityofmoney,thatis,theaveragenumberoftimesthatthemoneystock(M)isspenttobuyfinaloutputduringayear.Specifically,VisdefinedasbeingequaltoPQ/M.Anexamplewillmaketheunderstandingofthisclearer.Supposethatthemoneystockis$100millioninagivenyear.Assumethatthenationalincomeinthesameyearis$400 12EconomicsforFinancialMarketsmillion(PQ).Thismeansthatthegivenmoneysupply,$100million,hasfinancedspendingof$400million.Howisthispossible?Well,whenyouspendmoneyinashop,theownerspendsitonre-stocking.Hissupplierinturnusesittopayhissupplierandsoon.Inthiswaythesameamountofmoneyfinancesexpendituresofalargeramount.Theextenttowhichmoneyisspentinthiswayismeasuredbyitsvelocityofcirculation.Inthisexample,velocityisequalto4,i.e.,PQ/M=$400million/$100million=4.Thus,asV=PQ/M,thenrearrangingthetermswederivethetruismthatMV=PQ.Inthehandsoftheearlyclassicaleconomists,however,thistruismbecamethebasisofthequantitytheoryofmoney.Thequantitytheoryofmoneyisthepropositionthatvelocity(V)isreasonablystable.Therefore,achangeinthequantityofmoney(M)willcausethemoneynationalincome(PQ)tochangebyapproximatelythesamepercentage.If,forexample,themoneystock(M)increasesby20percent,thenclassicaleconomistsarguethatvelocity(V)willremainreasonablystable.Asaconsequencenominalnationalincomewillriseby20percent.Inadditiontheyarguethatoverlongertimeperiods,output(Q)tendstobefairlyfixed,dependingonrealfactorssuchasthelevelofthecapitalstock,structureofthelabourforce,trainingandentrepreneurshipratherthanmon-etarydisturbances.Therefore,thelong-runeffectofachangeinMisonP,notonQ.SoMV($480million)equalsPQ($480million),i.e.,a20percentincreaseinthemoneysupplycausespricestoriseby20percent.Thesuccessofthistheoryinpredictingeconomicchanges,dependsontheextenttowhich:thegovernmentcancontrolthemoneysupply;whetherVisconstantornot;whetherQisconstantornot.Howmoneyaffectstheeconomy–thetransmissionmechanismItisnotunreasonabletoexpectthat,sinceoneofthemainfunctionsofmoneyistofacilitatetransactions,thedesiredamountofmoneybalanceswillvaryproportionallywiththe Whatdoyouneedtoknowaboutmacroeconomicstointerpretfinancialmarketvolatility?13leveloftransactionsand,therefore,withthelevelofincome.Ifthisrelationshipisfairlystable,forexample,oneholds10percentofincomeontheaverageofanysingletimeperiodintheformofmoneybalancesasopposedtoanyothertypeofassets,thenifsomethingcausesthesebalancestoincrease,onewillrestorethat10percentlevelbyspending.Asalreadydiscussed,thefactthatthereisastablerelationshipbetweenmoneybalancesheldbypeopleandtheleveloftheirincomeisoneofthekeyassumptionsoftheQuantityTheory.Adifferentwayofseeingthismechanisminactionistothinkofwhatyouwoulddoifarichauntleftyou$10000inherwill(althoughasillyexample,itworks!).Wouldyoukeep$10000inthebankorascash?Perhapsyouwouldholdsomeofyourlegacyinoneoftheseforms,butperhapsyouwouldspendapartofit.Andthisisthepoint.Holding$10000inmoneybalancesdoesnotprovidethesamepleasureorservicesasholding$9000inmoneybalancesand$1000intheformofnewclothes,anewDVDandalongholiday.Inotherwords$10000wastoomuchmoneyinthesensethatitwastoomuchofaparticularasset.Nowmoneyisinstantlytransformedintogoodsandservices.Thereisaperfectdegreeofsubstitutabilitybetweenmoneyandotherthings.ThisisanotherimportantaspectoftheQuantityTheory.Ifmoneyissubstitutableforothergoodsthenincreasesordecreasesinthequantityofmoneyareboundtobereflectedinthedemandforgoods.Sinceonaquarter-to-quarterbasisoutputofgoodsandservicesisunlikelytovarysignificantly,thentheseincreasesordecreasesindemandwillbereflectedinchangesinprices.Thereis,however,agroupofeconomistswhoarguethatmoneyhasitsmaininfluencenotongoods,butonfinancialassetsonly.SothemonetarytransmissionmechanismisthesameasthatdescribedfortheQuantityTheoryapproachbutwiththedifferencethatpeoplemaywell‘buy’or‘sell’(holdless)ofotherfinancialassets.ThisapproachiscalledtheKeynesianTheoryofthetransmissionmechanism(aftertheeconomistJ.M.Keynes).TheKeynesianTheoryexamineswhathappensifwehaveaseriesofgoodsthatareclosesubstitutes.Underthesecircum-stancesthen,increasing/decreasingthequantityofonegoodwillaffectthepricesoftherest,asconsumersshifttheirpurchasesfromonegoodtotheother.Toappreciatethispointitisimportanttorememberthatthereturnonanassetvariesinverselywithitsprice.(SeeChapters2and3forfurtherdiscussionofthisprinciple.) 14EconomicsforFinancialMarketsThereare,ofcourse,alotofassetswithfixedcapitalandinterestratevalues.Adepositwithabankof$100willyieldsay10percentp.a.,andsinceitscapitalvalueisfixedsoistherateofreturn–unlessofcoursethebankchangestheinterestrateitpaysdepositors.Nowifdemandforacertainassetincreasesthentherewillbeadownwardpressureontherateofreturn.Ifbanksarebulgingwithdepositstheyaremorelikelytodecreaseinterestratesthanincreasethem.Ifontheotherhandthedemandfor,saygovernmentbondsdecreasesthenthiswillleadtoanupwardpressureoninterestrates.Soyoucanseewhatmattershereisthedifferentialsbetweentheyieldsofdifferentassetsandthespeedbywhichtheinterestrates(i.e.,theratesofreturn)areadjusted.Butinterestratesarenotonlyreturnsforinvestors,theyarealsocostsforborrowers.Soincreasesinthesupplyofmoney(thebankexample)leadingtoashifttootherfinancialassetswillalsoleadtoadownwardpressureoninterestrates.Certainclassesofexpenditure,suchasbusinessinvestment,consumerspendingondurables(andespeciallyonhousing),arefairlyinterest-rateelastic,i.e.,theyrespondquicklytochangesininterestrates.So,theargumenthereisthatlevelsofaggregatedemandandexpenditurecanbeaffectedbychangingthequantitiesofmoneyandthereforebyaffectinginterestrates,whichintheirturnaffectexpenditures.Thusasthemoneysupplyrises,Keynesiansargue,returnsonfinancialassetsalterfirst,beforeexpenditures.Monetaristsbelievethatexpendituresalterfirstandreturnsonfinancialassetsalterlater.Wecancrudelysummarizethe‘transmissionmechanism’oftheKeynesianandQuantity(usuallycalledthe‘MonetaristApproach’)Theoriesasfollows.Keynesiantransmissionmechanism:Changesinquantityofmoney➩interestratechanges➩changesinthelevelofexpenditureswhichareaffectedbychangesintheinterestrate.Monetaristtransmissionmechanism:changesinthequantityofmoney➩changesinexpenditures(withlikelyeffectsonthepricelevel,especiallyintheshortrun).Youcanseethatthereisanextra‘link’intheKeynesianmechanism.Ifinterestratesdonotrespondtochangesinthequantityofmoneyorifaggregatedemanddoesnotrespondto Whatdoyouneedtoknowaboutmacroeconomicstointerpretfinancialmarketvolatility?15changesininterestratesthenvaryingthequantityofmoneywillnothavemucheffectoneitherpricesorthelevelofaggregatedemand.Thisisaverydifferentviewfromthatofthemonetarists.Sowhethervariationsinthequantityofmoneyhavetheireffectsprincipallyupongoodsorfinancialassetsdependsontherespectivedegreesofsubstitutability.Monetaristsconsidermoneytobeauniquefinancialassetdistinguishedbyitsabilitytoserveasamediumofexchange.Keynesianstendtoviewmoneyasjustanotherfinancialassetandseethekeydistinc-tionbetweenfinancialassetsingeneralandgoods.Themodernquantitytheory–modernmonetarismAsdiscussedabove,theQuantityTheoryofmoneywasdiscreditedbytheevidenceofthegreatdepressioninthe1920sand1930sandthesubsequentascendancyofKeynesianideas.Intheearly1950sMiltonFriedmanofChicagoUniversitybegantoreformulatetheQuantityTheory.Sincethenhisideashavebecomeincreasinglyinfluential.Friedman’sbasicadvancewastoconcedemanyoftheargumentsofKeynesasdescriptionsoftheshort-runbehaviouroftheeconomy,albeitwithreservations,whilstretainingthebasictenetsofthequantitytheoryaslonger-termpropositions.Friedmanandthemonetaristsretainedtheoldquantitytheoryassumptionsthat:money(M)washeldfortransactionspurposes;velocity(V)wasconstantinthelongerrun(oratanyrategrewataconstantrate);output(Q)wasunaffectedbymoneyinthelongrun.ButFriedmanconcededthat:short-termmovementsinvelocitywerepossibleinresponsetofluctuationsinthemoneysupply;velocityalsodependedoninterestrates(althoughheassertedthatthesensitivitywasnotgreat);short-termmovementsinoutputcouldbeproducedbyvaryingthemoneysupply.Indeed,Friedmanarguedthatchangesinmoneyhadpowerful,albeittemporary,effectsonoutput. 16EconomicsforFinancialMarketsThemonetaristviewoftheworldisperhapsmoreeasilyunderstoodbyexplaininghowtheyseetheeffectofariseinthemoneysupply(thetransmissionmechanism).InitiallyariseinMisabsorbedbyafallinV,i.e.,theextramoneysupplyishoarded.Veryquickly,however,economicagentsbegintorundowntheirexcessmoneyholdings.Theydothispartlybyincreasingspending,partlybybuyingfinancialassets(suchasstocksandshares)andpartlybybuyingupphysicalassets(e.g.housesandpaintings).Thisbidsupthestockmarketandreducesinterestrates,stimulatinginvestment.Throughthesediversemecha-nismstheriseinmoneyfeedsthroughtoanincreaseinthepaceofeconomicactivity.WhilstafallinVtakesupalltheslackinitially,Qsoonbeginstoincrease.However,whilstanindividualcanreplacehisholdingofmoney(byexchangingitforgoodsandservices)thisisnotthecasefortheeconomyatlarge.Theeffectoftheincreaseinaggregatespendingistocausepricestorise.Firmsinitiallyrespondtohigherdemandbyproducingmoreandwideningmark-ups(whichraisespricesimmediately).Extraoutputrequiresmoreworkersandtheassociatedtighteningofthelabourmarketpushesupwages,whichraisescostsandfeedsthroughintohigherprices.Aspricesrisethedemandformoneyisincreasedandtheexcessmoneyholdingsthatbeganthewholeprocessareeroded.Whenpriceshaverisenbythesameproportionastheriseinthemoneysupply,excessmoneybalanceshavedisappearedandVandQreturntotheirnormallevel.ThemonetaristsbelievethatchangesinMhaveonlytempo-raryeffectsonoutputbuthavepermanenteffectsonprices.ThemonetaristclaimsrevisitedAsalreadyindicated,thebasicmonetaristclaimisthatpricesaredeterminedbythesupplyofmoney.Allthatagovernmenthastodo,inordertocontrolthelevelofpriceincrease,istoobeyafixedmonetaryrulethatwouldpermitthemoneysupplytoincreasebynomorethantheanticipatedgrowthinoutput.Anydeparturefromthisrule,oranyattempttouseothermeans,suchasfiscalmeasures,toinfluenceeconomicdevelop-ments,willbeself-defeating.ThebasisfortheseclaimshasbeenfullyadvancedbyProfessorMiltonFriedmaninAMonetaryHistoryoftheUnitedStates1867–1960,writteninassociationwithAnnaJacobsonSchwarz.AccordingtoFriedman,theUnitedStates’experienceoverthisperiodshowsthat: Whatdoyouneedtoknowaboutmacroeconomicstointerpretfinancialmarketvolatility?17changesinthebehaviourofthemoneystockhavebeencloselyassociatedwithchangesineconomicactivity,moneyincomesandprices;theinterrelationbetweenmonetaryandeconomicchangehasbeenhighlystable;andmonetarychangeshaveoftenhadanindependentorigin–theyhavenotsimplybeenareflectionofchangesineconomicactivity.Thesethreepropositions,statedsomewhatrigorously,havebecomeembodiedinabodyofdoctrinewhichcanbesumma-rizedasfollows:Pastratesofgrowthinthestockofmoneyarethemajordeterminants(indeed,virtuallytheonlysystematicnon-randomdeterminants)ofthegrowthofGNPintermsofcurrentprices.ItfollowsfromthisthatfiscalpoliciesdonotsignificantlyaffectGNPinmoneyterms,althoughtheymayalteritscompositionandalsoaffectinterestrates.ItalsofollowsthattheoverallimpactonGNPinmoneytermsofmonetaryandfinancialpoliciesis,forpracticalpurposes,summedupinthemovementsofasinglevariable,thestockofmoney.Consequently,theargumentgoesthatmonetarypolicyshouldbeexclusivelyguidedbythisvariable,withoutregardtointerestrates,creditflowsorotherindicators.Nominalinterestratesaregearedtoinflationaryexpectationsandthus,withatimelag,toactualinflation.Althoughtheimmediatemarketimpactofexpansionarymonetarypolicymaybetolowerinterestrates,itisfairlysoonreversedwhenpremiumsfortheresultinginflationareaddedtointerestrates.ThecentralbankcanandshouldmakethemoneystockgrowatasteadyrateequaltotherateofgrowthofpotentialGNPplusatargetrateofinflation.Thereisnoenduringtrade-offbetweenunemploymentandinflation.Thereisinsteadauniquenaturalrateofunemploy-mentforeacheconomy,whichallowsforstructuralchangeandjobsearchbutwhichcannotbedepartedfrominthelongterm.Governmentpolicywillproduceever-acceleratinginfla-tionifitpersistentlyseeksalowerthannaturalrateofunemployment.Ifitseeksahigherrate,therewillbeaneveracceleratingdeflation.Thenaturalrateofunemploymentcannotbeidentifiedexceptthroughpracticalexperience;itistheratethatwillemergeifthepropersteady-growthmone-tarypolicyispursued. 18EconomicsforFinancialMarketsTheattractivesimplicityofthisdoctrineiseasilyrecognized.Theessenceofthemonetaristpositionisthatincreasesinpricesandwagescanbeheldincheckbynothingmorecomplicatedthantheapparentlysimpledeviceofcontrollingtheamountofmoneyincirculation.Ideally,aconditionofnilinflationisachievedwhentheincreaseinthemoneysupplyequalstheincreaseintherealoutputoftheeconomy.Sincebothwageandpriceincreasescanonlyoccurifextramoneytofinancethemismadeavailable,thennoincreasewilltakeplaceifnomoremoneyisprovided.Ifattemptsaremadebyfirmsorwage-earnerstogainanadvantagebyputtingupthecostoftheirgoodsandservicesontheonehandorlabourratesontheother,aconstantmoneysupplywillmeanunsoldgoodsandservicesforthefirmandthelossofjobsforlabour.Thus,sotheargumentgoes,aslongasthegovernmentispreparedtocontrolthemoneysupply,everyonewillseeitasbeinginhisinteresttoexerciserestraint,andinflationwillbereducedtowhateverlevelisdeemedtobeacceptable.Thepracticalproblemofapplyingmonetaristideasisthesubjectmatteroftheremainderofthischapter.MonetarismandFederalReserveoperatingtargetsfrom1970tothepresentFortheFederalReserveamonetarypolicystrategyisaplanforachievingitseconomicobjectives.TheFederalReservenormallytriestoimplementsuchaplanbyfollowinganoperatingtargetthatisaself-imposedguidelineforconductingmonetarypolicyovertime.InpracticetheFederalReservehasvarieditsoperatingtargetsinrecentyears.Since1970fourseparatetargetshavebeenapplied.Theseare:TargetingMonetaryGrowthandtheFedFundsRate:1970to1979TargetingNon-BorrowedReserves:October1979toOctober1982TargetingBorrowedReserves:October1982toOctober1987TargetingFederalFunds:October1987tothePresent. Whatdoyouneedtoknowaboutmacroeconomicstointerpretfinancialmarketvolatility?19ChangesinOperatingProcedure1979–1996aresummarizedinTable1.1.Developmentsafterthisdatearediscussedinthetext.ForreadersnotneedingtoknowtheintricaciesofFederalReserveoperatingstrategiesthenextsectioncanbesafelyskipped.TargetingmonetarygrowthandtheFedfundsrate:1970to1979In1970theFederalReserveformallyadoptedmonetarytargetswiththeintentionofusingthemtoreduceinflationgraduallyovertime.Thetechniquesforsettingandpursuingmonetarygrowthtargetsdevelopedgradually,withfrequentexperimentationandmodificationofprocedurestakingplaceinthefirstfewyearsofthe1970s.Nonetheless,untilOctober1979theframeworkgen-erallyincludedsettingamonetaryobjectiveandencouragingtheFedfundsratetomovegraduallyupordownifmonetarygrowthwasexceedingorfallingshortoftheobjective.TheFedfundsrate,asanindicatorofmoneymarketconditions,becametheprimaryguidetoday-to-dayopenmarketoperations.FreereservesservedasanindicatorofthevolumeofreservesneededtokeeptheFedfundsrateatthedesiredlevel.TheroleoffreereservesasindicatorsofthestrengthofmonetarypolicyisillustratedinTable1.2.Tightmonetarypolicyisreflectedinafallinfreereservesandaneasingofmonetarypolicyisreflectedinariseinfreereserves.Excessreservesaretotalreservesminusrequiredreserves.Thenetdifferencebetweenexcessandborrowedreservesiscalledfreereservesand/ornetborrowedreserves;thelattertermissometimesusedinsteadofreferringtoexcessandborrowedreservesseparately.ThemethodofcalculatingnetfreereservesandnetborrowedreservesisillustratedinFigure1.2.Table1.3illustratesthataseasymonetarypolicyoccursasnetfreereservesrise,andatightmonetarypolicyoccursasfreereservesfall.TheFederalOpenMarketCommittee(FOMC)tradingdesk(knownastheFedopenmarketdesk)usestheforecastsofthesereservefactorstogaugetheappropriatedirectionandmagni-tudeforopenmarketoperations,irrespectiveofthechoiceofoperatingtarget.Underthe1970–1979procedures,theFOMCinstructedthetradingdesktoraisetheFedfundsratewithinalimitedbandifthemonetaryaggregatesweresignificantlyabovethedesired 20EconomicsforFinancialMarketsTable1.1ChangesinOperatingProcedures,1979–1996PeriodOperatingProceduresImplicationsKeyElementsNBRPathFedFundsOtherRate1979–82TargetforNBRBasedontheHighlevelsofNosignificantquantityFOMC’sdesiredvolatility;accommodationmoneygrowthautomaticofshort-runmovementsinfluctuationsinthefundsratereservesoverawideanddemand;flexiblerangeoperationscouldsignalpolicyshifts1983–87DegreeofConsistentwithModestamountPartialreservetheFOMC’sofvolatilityaccommodationpressure;intendedlevelswithinandofshort-runtargetsforofdiscountbetweenfluctuationsinborrowedwindowmaintenancereservesreservesborrowingandperiodsdemand;thefundsrateoperationscouldsignalpolicyshifts1989–93DegreeofConsistentwithLimitedNearlycompletereservetheFOMC’svariationswithinaccommodationpressure;intendedmaintenanceofshort-runassumedinitialFederalfundsperiodsaroundfluctuationsinborrowingratetheintendedreservesallowanceleveldemand;operationscouldsignalpolicyshifts1994–96DegreeofConsistentwithLimitedNearlycompletereservetheFOMC’svariationswithinaccommodationpressureandintendedmaintenanceofshort-runassociatedFederalfundsperiodsaroundfluctuationsinfederalfundsratetheintendedreservesratetarget;newleveldemand;policyoperationsdodisclosurenotsignalpolicyproceduresshiftsNote:NBR=non-borrowedreservesSource:UnderstandingOpenMarketOperations,M.A.Akhtar,FederalReserveBankofNewYork Whatdoyouneedtoknowaboutmacroeconomicstointerpretfinancialmarketvolatility?21Table1.2Freereserves:anindicatorofthestrengthofmonetarypolicyExcessreserves(ER)–Discountwindowborrowing(DWB)=FreereservesDWB>ER=Netborrowedreserves(NEBR)ER>DWB=Netfreereserves(NFR)TightmonetarypolicyEasymonetarypolicy–Freereservesfall–Freereservesrise–Netborrowedreservesrise–Netborrowedreservesfallgrowthrates,ortolowertheFedfundsratewithinthatbandiftheaggregateswerebelowthem.TheprocedurerequiredthestafftoestimatewhatlevelofFedfundsratewouldachievethedesiredmoneygrowth.TheFedfundsrateworkedbyaffectingtheinterestratesthatbanksbothpaidandchargedcustomersandhencethedemandformoney.Duringmostofthe1970s,theFOMCwasreluctanttochangethefundsratebylargeamountsatanyonetime.Partofthatreluctancereflectedawishtoavoidshort-termreversalsoftherate.Keepingeachrateadjustmentsmallminimizedtheriskofoverdoingtheratechangesandthenhavingtoreversecourse.TheseprioritiesmeantthattheFOMCwashandicappedattimeswhenitsensedalargeratemovemightbeneededbutwasuncertainaboutitssize.Theadjustmentsinthefundsrateoftenlaggedbehindmarketforces,allowingtrendsinmonetarygrowth,theeconomy,andpricestogetaheadofpolicy.Thekeyequations:TR=RR+ERExampleNBR=RR+ER–DWBNFRorNEBR=ER–DWB40000=39000+100039700=39000+1000–300700=1000–300Where:TR=TotalreservesRR=RequiredreservesER=ExcessreservesNBR=Non-borrowedreservesDWB=DiscountwithoutborrowingNFR=NetfreereservesNEBR=NetborrowedreservesFigure1.2Calculatingnetfreereserves(NFR)andnetborrowedreserves(NEBR). 22EconomicsforFinancialMarketsTable1.3Howdoyoumeasurethestrengthofmonetarypolicy?EasymoneyER>DWBFreereservesriseNetborrowedreservesfallNeutralmonetarypolicyFreereservesconstantTightmoneyDWB>ERFreereservesfallNetborrowedreservesriseSopriortoOctober1979,theSystemattemptedtoestimatetheleveloftheFedfundsrate,i.e.,theovernightinterestrateonreservefundsintheopenmoneymarket,consistentwiththerateatwhichitwantedM1andtheothermonetaryaggregatestogrow.ItthenusedopenmarketoperationstoholdtheFedfundsratewithinanarrowrangearoundthatlevel,intheshortrun.AnimportantdisadvantageofthisapproachinpracticewasthatwhenthepublicbecamefullyawarethattheFederalReservewasusingtheFedfundsrateinthisway,financialmarketsbecameverysensitiveintheshortruntoevensmallchangesintherate,andsmalladjustmentsintheratesometimesproducedstrongpoliticalreactions.BothconditionsmadeitdifficultfortheFederalReservetoadjusttheratesasfrequentlyaswasnecessaryforeffectivecontrolofthemonetaryaggregates.TargetingNon-BorrowedReserves:October1979toOctober1982Againstthisbackground,inOctober1979theFederalReservestoppedusingtheFedfundsrateasitsdirectcontrolinstru-mentandbegantofocusonvariousreservemeasuresinordertoimproveitsmonetarycontrolperformance.InOctober1979,PaulVolcker,whohadrecentlybecomeChairmanoftheBoardofGovernors,announcedfar-reachingchangesintheFOMC’soperatingtechniquesfortargetingthemonetaryaggregates.Theaccelerationofinflationtounaccept-ableratesovertheprecedingdecadeinspiredachangeinpriorities.ChairmanVolckerandotherFOMCmembersreal-izedthatturningaroundtheseinflationarypressures,whichhadcometopermeateeconomicrelations,wouldinvolvecosts.Interestrateswouldhavetorisesignificantlybeyondrecent Whatdoyouneedtoknowaboutmacroeconomicstointerpretfinancialmarketvolatility?23levels,althoughtheextentoftheincreasecouldnotbedeterminedinadvance.Increasedratevolatilitywasalsolikelytoaccompanytheeffortstohaltinflation.TheFederalReserve’scredibilitywiththepublicwaslowafterpreviouseffortstoslowinflationhadbeenfollowedbyfurtherpriceacceleration.ChairmanVolckerfeltthatonlystrongmeasurescouldrebuildpublicconfidence.FromOctober1979untillate1982,theFederalReserveusednon-borrowedreserves(NBR)asitsinstrument.Inthisregime,theSystemsetapathfornon-borrowedreservesthatitbelievedwasconsistentwiththedesiredpathsofthemonetaryaggre-gates.Withnon-borrowedreservesthuspredetermined,anychangeindepositoryinstitutiondemandfortotalreserves,occasionedbyadeviationofthemonetaryaggregatesfromtheirdesiredpaths,hadtobeaccommodatedbyacorrespondingchangeinthelevelofborrowingatthediscountwindow,eitherupwardsordownwards.Thechangeinborrowing,inturn,affectedtheFedfundsrateandothershort-terminterestrates,andhencethedemandformoney.Atatechnicalleveltherelationshipbetweenborrowingatthediscountwindowandshort-termrateswasthecentralrelation-shipinthenon-borrowedreserveregime.Ifthegrowthofthemonetaryaggregatesbegantoexceedthedesiredpaths,thedemandofdepositoryinstitutionsfortotalreserveswouldrise,whichwouldcausethelevelofborrowingatthediscountwindowtoincrease.TheincreasedborrowingwouldthenputupwardpressureontheFedfundsrateandothermarketrates,giventhegeneralreluctancetoborrowandtheFederalReserve’sadministrativerestrictionsonborrowing.Theriseinrates,finally,wouldreducethedemandformoneyandthegrowthofthemonetaryaggregates.Inimplementingthepolicy,theFedopenmarketdeskemphasizedthatitwastargetingreservesandnottheFedfundsratebyenteringthemarketataboutthesametimeeachday–usuallybetween9:30and9:45a.m.–toperformitstemporaryoperations.Itconfinedoutrightpurchasesorsalestoestimatedreserveneedsorexcessesextendingseveralweeksintothefuture.Itarrangedoutrightoperationsearlyintheafternoonfordeliverynextdayortwodaysforward.TheFedfundsratewasnotignored;itwasusedasanindicatoroftheaccuracyofreserveestimates.Bysettinganobjectivefornon-borrowedreservestheFederalReserveendedupbyallowingsomevariabilityintotalreserves,inanattempttodampeninterestratevariability.Nevertheless 24EconomicsforFinancialMarketsinterestratesweremuchmorevolatileaftertheFederalReserveswitchedtotargetingnon-borrowedreserves.Byallowingreservestovarysomewhat,theFederalReserveendeduppermittingthequantityofmoneytovaryfromitstargetlevel.Intheendtargetingnon-borrowedreservesledtosignificantvariationsinbothinterestratesandthequantityofmoney.TargetingBorrowedReserves:October1982toOctober1987InOctober1982theFederalReservetriedanoperatingprocedurethatlaybetweentargetingreservesandtargetingtheFedfundsrate.Itbegantotargetthelevelofborrowedreserves.BytargetingborrowedreservestheFederalReservetendedtostabilizefreereserves.ChangesinthebehaviourofM1hadledtheFOMCtoabandonthenon-borrowedreservesproceduresandtoempha-sizethelevelofdiscountwindowborrowingasthefocusofpolicyactions.Undertheborrowedreservesprocedurestherewasnolongeranautomaticresponseofinterestratestoamonetaryaggregateintermediatetarget.ToimplementapolicychangetheFOMCwouldtellthetradingdesktoaimforhigherorlowerlevelsofdiscountwindowborrowing.TotightenpolicytheborrowingtargetwouldberaisedandtheFedopenmarketdeskwoulduseopenmarketoperationstoreducenon-borrowedreserves.DecreasedreserveswouldputupwardpressureontheFedfundsrateandwithanunchangeddiscountratewouldresultinahigherlevelofdiscountwindowborrowing.TorelaxmonetarypolicytheborrowingtargetwouldbeloweredandtheFedopenmarketdeskwoulduseopenmarketoperationstoincreasenon-borrowedreserves.IncreasedreserveswouldputdownwardpressureontheFedfundsrateandwithanunchangeddiscountratewouldresultinalowerlevelofdiscountwindowborrowing.Tobesure,theborrowedreserveprocedurewasimplementedinawaysoasnottolosecontroloverFedfundsrate.Initsday-to-dayoperations,theFedopenmarketdeskconsiderednotjusttheassumedlevelofdiscountwindowborrowing,butalsothedegreeofuncertaintysurroundingthereserveestimates,aswellasothersignalsaboutreservemarketconditions,includingmovementsoftheFedfundsrate.Occasionally,theFedfundsratewasgiventhedominantpositioninassessingthereservepressures. Whatdoyouneedtoknowaboutmacroeconomicstointerpretfinancialmarketvolatility?25Onaverage,however,theFOMCandthetradingdeskusedtheintendedlevelofdiscountwindowborrowingasthemainfactorforevaluatingreserveavailabilityconditionsduring1983–1987,withshort-runmarketexpectationsbeingallowedtoplayarelativelymodestroleindeterminingthefundsrate.Inthissetting,theFederalfundsratehadconsiderableleewaytofluctuatewithoutchangesinthedesiredpolicystance.Throughmuchofthe1983–1987perioditwasnotunusualfortheaverageeffectiveFederalfundsratetovaryby20–40basispointsevenbetweenthosemaintenanceperiodsinwhichtheFOMChadnotsoughttochangethedegreeofreservepressure.TargetingtheFedfundsrate:1987tothepresentTheuseofaborrowedreservetargetingprocedureisdependentuponastabledemandfordiscountwindowborrowing.Begin-ninginthemid1980s,periodicchangesinbanks’demandforborrowedreservesmadeitincreasinglydifficulttoimplementtheborrowedreservesprocedure,leadingtheFOMCtomovebacktowardsaFedfundsrateprocedure.ThechangeinprocedurewasprecipitatedbytheOctober1987stockmarketcollapse,withmanystocksfallingbyoveronethirdinasingleday.TohelppreventabroaderfinancialcrisistheFederalReserveannouncedthatitstoodreadytoprovideasmuchliquidityasneeded.Italsodecidedtokeepinterestratesstabletopreventfurthervolatilityinthepricesoffinancialinstruments.Todothis,itswitchedtoaFedfundsratetargetonceagain.Theoperatingproceduresthatbeganinthelate1980shavebeenusedthroughoutthesubsequentperiod.WhiletheFOMCcontinuestoexpressitspolicystanceinthedirectiveintermsofthedegreeofpressureonreservepositions,theFedfundsrateisnowtheprincipalguideforevaluatingreserveavailabilityconditions,andhasthereforebecometheday-to-daypolicyobjectiveforopenmarketoperations.TheFedopenmarketdeskstillusesananticipatedlevelofdiscountwindowborrow-inginconstructingthenon-borrowedreservespath,butitcompensatesfordeviationsfromthatanticipatedlevelbymodifyingthenon-borrowedreservesobjective,formallyorinformally,soastomaintaintheFOMC’sintendedFedfundsrate.Onaverage,changesinthedemandforreservesduringthemaintenanceperiodarenowmorefullyaccommodatedbyadjustingthesupplyofnon-borrowedreservesthanwasthecaseinthe1983–1987period.Asaresult,theaveragelevelof 26EconomicsforFinancialMarketsthefundsrateduringtheperiodismorecloselyassociatedwiththeintendeddegreeofreservepressuresthanbefore.TheFederalfundsratedoesfluctuateduringthemaintenanceperiod,butitsaveragevaluefromoneperiodtothenextremainsessentiallythesameaslongasthereisnochangeintheintendedstanceofmonetarypolicy.DoesamovetotargetingFedfundsmeanthattheFederalReservenolongertargetsthemoneysupply?TraditionaldiscussionofmonetarypolicyfocusesontheassumptionthattheFedReserveinfluencestheeconomybycontrollingthemoneysupply.Bycontrast,whenyoureadaboutFederalReservepolicyinthemedia,thepolicyinstru-mentmentionedmostoftenistheFedfundsrate,whichistheinterestratethatbankschargeoneanotherforovernightloans.Whatthenisbeingtargeted?IsitthemoneysupplyorisittheFedfundsrate?Theanswerisboth.AsdiscussedaboveinrecentyearstheFederalReservehasusedtheFedfundsrateasitsshort-termpolicyinstrument.ThismeansthatwhentheFOMCmeetseverysixweekstosetmonetarypolicy,itvotesonatargetforthisinterestratethatwillapplyuntilthenextmeeting.Afterthemeetingisover,theFederalReserve’sbondtradersinNewYorkaretoldtoconducttheopen-marketoperationsnecessarytohitthetarget.Theseopen-marketoperationschangethemoneysupplyandmovetheexistingFedfundsratetothenewtargetFedfundsratethattheFOMChaschosen.Asaresultofthisoperatingprocedure,FederalReservepolicyisoftendiscussedintermsofchanginginterestrates.Keepinmind,however,thatbehindthechangesininterestratesarethenecessarychangesinthemoneysupply.Anewspapermightreport,forinstance,that‘theFedhasloweredinterestrates’.Tobemoreprecise,wecantranslatethisstatementasmeaning‘theFederalOpenMarketCommitteehasinstructedtheFederalReservebondtraderstobuybondsinopen-marketoperationssoastoincreasethemoneysupply,andreducetheequilibriuminterestratetohitanewlowertarget’.WhyhastheFederalReservechosentouseaninterestrate,ratherthanthemoneysupply,asitsshort-termpolicyinstru-ment?Onepossibleansweristhatthemoneysupplygrowthcanbesomewhatunpredictable.Targetinganunpredictablemoneysupplycanleadtoperverseresults.Ifthisissuchaproblemthenapolicyoftargetingtheinterestrateleadsto Whatdoyouneedtoknowaboutmacroeconomicstointerpretfinancialmarketvolatility?27greatermacro-economicstabilitythanapolicyoftargetingthemoneysupply.Anotherpossibleansweristhatinterestratesareeasiertomeasurethanthemoneysupply.TheFederalReservehasseveraldifferentmeasuresofmoneythatsome-timesmoveindifferentdirections.Ratherthandecidingwhichmeasureisbest,theFederalReserveavoidsthequestionbyusingtheFedfundsrateasitsshort-termpolicyinstrument.WhateverthereasonforchoosingtheFedfundsratetarget,abeliefintheroleofmonetarismstillliesbehindcurrentFederalReserveoperatingtactics.NewFOMCdisclosureproceduresAnother,morerecent,developmentthathasaffectedtheconductofopenmarketoperationsconsiderablywastheFOMC’schangeinprocedures,initiatedinearly1994andformalizedinearly1995,fordisclosingmonetarypolicydeci-sionsimmediatelyaftertheyaremade.Untiltheendof1993,theCommittee’spolicydecisionswereannouncedwitha5–8weeklag,throughthereleaseofitsminutes,whichcontainthedomesticpolicydirective.However,anychangesinthestanceofmonetarypolicywerequicklycommunicatedtofinancialmarketsthroughopenmarketoperationsastheFedopenmarketdeskimplementedthepolicydirective.Underthenewprocedures,whicharenowstandard,changesintheFOMC’sstanceonmonetarypolicy,includinganyintermeet-ingchanges,areannouncedonthedaytheyaremade.TheFOMCcontinuestoreleaseitsdirectiveforeachmeetingwithadelay,ontheFridayafterthenextmeeting.Beforetherecentdisclosureproceduresforpolicydecisionswentintoeffect,marketparticipantscloselywatchedtheFedopenmarketdesk’soperationstodetectpolicysignals.Theuseofopenmarketoperationstosignalpolicychangescreated,attimes,considerablecomplicationsfortheFOMCtradingdesk,especiallywhenthefundsrateandthereserveestimatesgaveconflictingsignals.Justasimportantly,theFedopenmarketdeskalsofacedconsiderablerisksthatitsday-to-daytechnicalordefensiveoperationswouldbeviewedasindicatorsofpolicymoves.Suchriskswereheightenedduringperiodswhenmarketparticipantsexpectedshiftsinpolicy.TherecentdisclosureprocedureshaveessentiallyfreedtheFedopenmarketdeskfromtheriskthatitsnormaltechnicalordefensiveoperationswouldbemisinterpretedaspolicymoves.Openmarketoperationsnolongerconveyanynewinformation 28EconomicsforFinancialMarketsaboutchangesinthestanceofmonetarypolicy.Inimplementingthedirective,theFedopenmarketdeskcarriesoutapolicythatisalreadyknowntofinancialmarketsandthepublicatlarge,andisnolongerconcernedaboutusingaparticulartypeofoperationtosignalachangeinpolicy.Ofcourse,marketpartici-pantsspeculate,justastheyalwaysdid,aboutpossiblefuturepolicymoves,especiallyintheperiodimmediatelyleadinguptotheFOMCmeetings.But,ingeneral,theynolongercloselywatchday-to-dayopenmarketoperationstodetectpolicysignals.OnOctober2,1997theFederalReserveannouncedthattheFOMCpolicydirectivehadbeenrewordedattheCommittee’smeetingonAugust19.ThedirectivenowspecifiesanexplicittargetfortheFedfundsrate,andalsoexpressesthebiastopossiblefutureactionintermsoftherate.Previously,theoperationalsectionsofthedirectivehadbeenexpressedintermsofthedegreeofpressureonreservepositions.ThisisdiscussedfurtherinChapter11.Figure1.3providesausefultaxonomyoftheinterrelation-shipbetweenthedifferentcomponentsofNominalGNPandthosemarket-sensitiveeconomicindicatorsthatmostcloselyinfluenceit.TheNon-AcceleratingInflationRateofUnemployment(NAIRU)AswillbediscussedfurtherinChapter6,onthefirstFridayofeverymonththeUSBureauofLabourStatisticsreleasesthelatestdataonemploymentandunemploymentintheUnitedStates.Sharpmovementsinfinancialmarketshaveoftenfollowedthesereleases.Inparticular,marketshavetakenlower-than-expectedunemploymentratestomeanthatinfla-tionisabouttoaccelerate,resultinginfallingstockpricesandincreasinginterestrates.Theaveragecitizenwouldfindthistobearatherstrangeritual.Isn’tlowunemploymentgoodforthecountry?Andwhyislowunemploymentsupposedtoleadtohigherinflationanyway?Theseareimportantanddifficultquestions.Aninfluentialeconomictheory,however,arguesthattheanswersareeasyandwidelyfoundinmacroeconomicstextbooks.Low Whatdoyouneedtoknowaboutmacroeconomicstointerpretfinancialmarketvolatility?29Non-NominalConsumerResidentialresidentialInventoryGovernmentNetGNP=expenditure+fixed+++fixedinvestmentexpenditure–exportsinvestmentinvestmentHousingDurableBudgetGNPCarstartsandgoodsManufacturingdeficit/deflatorsalespermitsordersinventoriessurplusConstructionConsumerBusinessEmploymentspendingPPISpendinginventories/report(non-(residential)salesresidential)IndustrialRetailNewproductionsaleshomesalesPersonalCapacityincomeandutilizationconsumerexpenditureEmploymentConsumercostindexcreditCPILeadingindicatorsVendordeliveriesindexAverageearningsFigure1.3GNPbrokendownbyitsconstituentmarket-sensitiveeconomicindicators.unemployment,thistheoryimplies,isunambiguously‘good’onlyuptoapoint.Ifunemploymentfallsbelowthispoint,knownasthenon-acceleratinginflationrateofunemployment(NAIRU),inflationtendstoaccelerate.OpinionsaboutthecurrentlocationoftheNAIRUvary,butmanypublishedestimatesintheUSplaceitcloseto5percent.Sincerecentunemploymentfigureshavebeenconsistentlybelowthatrange,adherentstothistheorypredictthatinflationwillaccelerate.Wereturntotheseideasthroughoutthetextandprovidesomeflavouroftheideasbelow. 30EconomicsforFinancialMarketsThePhillipscurve,thenaturalrateandNAIRUTheideathatunemploymentmaybetoolowtobeconsistentwithstableinflationisofrelativelyrecentvintage.Itsoriginscanbetracedtothe1960sand1970sdiscussionabouthowtointerpretthethenrecentlydiscovered‘Phillipscurve’,anempiricalassociationbetweeninflationandunemployment,namedaftertheAustralianeconomistbasedattheLondonSchoolofEconomics,A.W.Phillips,whopopularizedtheidea.Someaspectsofthisdebateareusefulforthediscussionsthatcomelaterinthetext.Phillips’s(1958)analysisofalmostacenturyofUKdatashockedtheeconomicsprofession.Phillipsfocusedontherelationshipbetweenwagesandunemploymentanddiscov-eredthestrikingfactthattherateofchangeinnominalwageshadanegativecorrelationwithunemployment.Soonafter-ward,SamuelsonandSolow(1960)showedthatasimilarrelationheldusingUSdata.Moreover,SamuelsonandSolowarguedthatchangesinnominalwageswerepositivelyrelatedtooverallinflation,thusrecastingthewageunemploymentrelationdiscoveredbyPhillipsintotheinverserelationbetweenpriceinflationandunemployment,whichbecamemorecommonlyknownasthePhillipscurve.ThediscoveryofthePhillipscurvegeneratedaheateddebateaboutitsimplicationsforeconomicpolicy.Inpartic-ular,researchfocusedonwhetheramonetaryauthority,suchastheFederalReserve,could‘buy’lessunemploymentatthecostoffasterinflation.SomearguedthattheexistenceofaPhillipscurveimpliedthatunemploymentcouldbeperma-nentlyloweredifinflationwerekeptatapermanentlyhigherlevel.Others,inparticularFriedman(1968)andPhelps(1968),arguedthattherewasaninflation–unemploymenttrade-offintheshortrunbutnotinthelongrun.Injustifyingtheirthesis,FriedmanandPhelpscoinedtheterm‘naturalrateofunemployment’.TounderstandFriedmanandPhelps’sargumentconsiderfirstaneconomywithoutpricesurprises,soactualinflationisalwaysequaltopreviouslyexpectedinflation.Insuchaneconomy,someworkerswouldalwaysbeobservedtobeunemployedandlookingforajob.Thisphenomenonmaysimplyreflectthefactthat,sinceworkersandjobsareheterogeneous,unemployedworkersandfirmsmaytaketimetosearchforadequatematches.Hence,evenifinflationwerealwaysperfectlyforeseen,theeconomywouldexperiencea Whatdoyouneedtoknowaboutmacroeconomicstointerpretfinancialmarketvolatility?31positiverateofunemploymentwhichiswhatFriedmanandPhelpscalled‘natural’.Whatifinflationwasnotperfectlyforeseen?FriedmanandPhelpsarguedthatunexpectedlyhighinflationwouldmakeactualunemploymentfallbelowitsnaturalrate,butonlyintheshortrun.Thisdeclinewouldhappen,inparticular,ifwagecontractshadbeennegotiatedonthebasisofpreviouslyexpectedinflation,inwhichcaseaninflationsurprisewouldreducereal(inflation-adjusted)wagesandstimulateemploy-ment.Oneimplicationofthisideaisthatamonetaryauthor-itycouldindeed‘buy’lowerunemploymentbyinducinginflationtoriseabovepreviouslyexpectedinflation.Butthiseffectwouldbeonlytemporary,becauseeconomicagentswouldeventuallylearntoforecastinflationcorrectly,andthedifferencebetweenexpectedinflationandactualinflationwouldtendtodisappear.Althoughunexpectedaccelerationsininflation,engenderedbymonetarypolicy,may‘cause’unemploymenttofallbelowthenaturalrate,theconverseneednothold.Withagivenmonetarypolicy,theFriedman–Phelpstheoryhadnoimplicationsforwhethermovementsintheunemploymentratehaveaninde-pendenteffectoninflation.Insubsequentresearch,asubtlybutclearlydifferentviewontherelationbetweeninflationandunemploymentemerged.Accordingtothisview,inflationtendstoacceleratewheneverunemploymentfallsbelowaparticularnumber,whichhascometobeknownasthe‘non-acceleratinginflationrateofunemployment’,orNAIRU.TheNAIRUconceptwasfirstproposedbyModiglianiandPapademos,whopositedtheexistenceofarateofunemploymentsuchthat,‘aslongasunemploymentisaboveit,inflationcanbeexpectedtodecline’(1975,p.142).Theintuitionisthatlowunemploymentislikelytointensifywagepressuresandconsequentlytoresultinageneralizedwageincrease.Assumingthatfirmsmanagetopassthiscostincreasetoconsumersintheformofhigherprices,afallinunemploymentislikelytobeassociatedwithanincreaseininflation.Similarly,anincreaseinunemploymentmustresultinafallininflation.Theremust,therefore,bealevelofunemploymentsuchthatinflationcanbeexpectedtoremainconstant;thislevelistheNAIRU.ItisimportanttobeawarethattheFriedman–PhelpsnaturalrateandtheNAIRUaredifferentconcepts.FriedmanandPhelpsdefinedthenaturalrateasanequilibriumratewhose 32EconomicsforFinancialMarketsvaluewasdeterminedbythecharacteristicsofthelabourmarket.Incontrast,theNAIRUispositedasanempiricalvalueratherthananequilibriumvalue.Moreimportantly,thetheoryoftheNAIRUimpliesthatlowunemploymentmaycauseinflationtoincreaseindependentlyofthecausesofthelowunemploymentand,inparticular,ofmonetarypolicy.ThisisnotanimplicationoftheFriedman–Phelpsnaturalratetheory.TheNAIRUconceptpervadescurrenteconomicpolicydiscus-sions.SincethepublicationofModiglianiandPapademos’sarticlenumerousstudieshave,notsurprisingly,focusedontheestimationoftheNAIRU.Iftherewereinfactastrong,stablerelationshipbetweenunemployment,aknownNAIRU,andinflation,thenonecouldcomparecurrentunemploymentwiththeNAIRUtopredictfutureinflationaccurately.However,thereareseriouslimitationsinthebasicideaforpolicymakersapplyingtheNAIRUconceptandthesearediscussedfurtherinChapters4and12. 2Thetimevalueofmoney:thekeytothevaluationoffinancialmarketsTimevalueofmoneyisacriticalconsiderationinunder-standingthekeyareasintheeconomicsoffinancialmarkets.Compoundinterestcalculationsareneededtodeterminefuturesumsofmoneyresultingfromaninvestment.Discounting,orthecalculationofpresentvalues,aconceptinverselyrelatedtocompounding,isatechniquewhichisusedtoevaluatethecashflowassociatedwiththevaluationoffinancialmarkets.Futurevalues–compoundingAdollarinhandtodayisworthmorethanadollartobereceivedtomorrowbecauseoftheinterestitcouldearnfromputtingitinasavingsaccount.Thisprocessofearninginterestonmoneyisknownascompounding.Compoundinginterestmeansthatinterestearnsinterest.Inordertoappreciatetheconceptsofcompoundingandtimevalueweneedsomedefinitions:Fn=futurevalue=theamountofmoneyattheendofyearnP=principali=annualinterestraten=numberofyearsThen,F1=theamountofmoneyattheendofyear1=principalandinterest=P+iP=P(1+i)F2=theamountofmoneyattheendofyear2=F(1+i)=P(1+i)(1+i)=P(1+i)21 34EconomicsforFinancialMarketsThefuturevalueofaninvestmentcompoundedannuallyatrateifornyearsisgivenbyequation(2.1)F=P(1+i)n=P·FVIF(2.1)ni,nwhereFVIFi,nisthefuturevalueinterestfactorfor$1.ThiscanbefoundinTable2.1.Table2.1Compoundedfuturevalueof$1(FVIF)Years1%2%3%4%5%6%7%8%9%Hence11.0101.0201.0301.0401.0501.0601.0701.0801.09021.0201.0401.0611.0821.1021.1241.1451.1661.18831.0301.0611.0931.1251.1581.1911.2251.2601.29541.0411.0821.1261.1701.2161.2621.3111.3601.41251.0511.1041.1591.2171.2761.3381.4031.4691.53961.0621.1261.1941.2651.3401.4191.5011.5871.67771.0721.1491.2301.3161.4071.5041.6051.7141.82881.0831.1721.2671.3691.4771.5941.7181.8511.99391.0941.1951.3051.4231.5511.6891.8381.9992.172101.1051.2191.3441.4801.6291.7911.9672.1592.367Example2.1Nadiaplaced$1000inasavingsaccountearning8percentinterestcompoundedannually.Howmuchmoneywillshehaveintheaccountattheendof4years?F=P(1+i)nnF=$1000(1+0.08)4=$1000·FVIF48,4FromTable2.1theFVIFfor4yearsat8percentis1.360.Therefore,F4=$1000(1.360)=$1360.Presentvalues–discountingPresentvalueisthepresentworthoffuturesumsofmoney.Theprocessofcalculatingpresentvalues,ordiscounting,isactu-allytheoppositeoffindingthecompoundedfuturevalue.In Thetimevalueofmoney:thekeytothevaluationoffinancialmarkets35connectionwithpresentvaluecalculations,theinterestrateiiscalledthediscountrate.RecallthatF=P(1+i)nnThereforeFn1P=n=Fn=Fn·PVIFi,n(2.2)(1+i)(1+i)wherePVIFi,nrepresentsthepresentvalueinterestfactorfor$1.ThiscanbefoundinTable2.2.Table2.2Presentvalueof$1(PVIF)Years1%2%4%5%6%8%10%12%15%Hence10.9900.9800.9620.9520.9430.9260.9090.8930.87020.9800.9610.9250.9070.8900.8570.8260.7970.75630.9710.9420.8890.8640.8400.7940.7510.7120.65840.9610.9240.8550.8230.7920.7350.6830.6360.57250.9510.9060.8220.7840.7470.6810.6210.5670.49760.9420.8880.7900.7460.7050.6300.5640.5010.43270.9330.8710.7600.7110.6650.5830.5130.4520.37680.9230.8530.7310.6770.6270.5400.4670.4040.32790.9140.8370.7030.6450.5920.5000.4240.3610.284100.9050.8200.6760.6140.5580.4630.3860.3220.247Example2.2Nadiahasbeengivenanopportunitytoreceive$20000sixyearsfromnow.Ifshecanearn10percentoninvestingit,whatisthemostsheshouldpayforthisopportunity?Toanswerthisquestion,onemustcomputethepresentvalueof$20000tobereceivedsixyearsfromnowata10percentrateofdiscount.F6is$20000,iis10percent,whichequals0.1,andnissixyears.PVIF10,6fromTable2.2is0.564.1P=$200006(1+0.1)=$20000(PVIF10,6)=$20000(0.564)=$11280 36EconomicsforFinancialMarketsThismeansthatNadiawhocanearn10percentonherinvestment,shouldbeindifferenttothechoicebetweenreceiv-ing$11280nowor$20000sixyearsfromnowsincetheamountsaretimeequivalent.Inotherwordsshecouldinvest$11280todayat10percentandhave$20000insixyears.BondandstockvaluationTheprocessofdeterminingsecurityvaluationinvolvesfindingthepresentvalueofanasset’sexpectedfuturecashflowsusingtheinvestor’srequiredrateofreturn.Thusthebasicsecurityvaluationmodelcanbedefinedmathematicallyasequation(2.3):nCtV=(2.3)t=1(1+r)twhereV=intrinsicvalueorpresentvalueofanassetCt=expectedfuturecashflowsinperiodt=1,...,nr=investorsrequiredrateofreturn.BondvaluationThevaluationprocessforabondrequiresaknowledgeofthreebasicelements:(1)theamountofthecashflowstobereceivedbytheinvestor,whichisequaltotheperiodicinteresttobereceivedandtheparvaluetobepaidatmaturity;(2)thematuritydateoftheloan;and(3)theinvestor’srequiredrateofreturn.Theperiodicinterestcanbereceivedannuallyorsemi-annually.Thevalueofabondissimplythepresentvalueofthesecashflows.Iftheinterestpaymentsaremadeannuallythenwederiveequation(2.4)nIMV=+=I(PVIFAr,n)+M(PVIFr,n)(2.4)t=1(1+r)t(1+r)nwhereI=interestpaymenteachyear=couponinterestrate(parvalue)M=parvalue,ormaturityvalue,typically$1000 Thetimevalueofmoney:thekeytothevaluationoffinancialmarkets37r=investor’srequiredrateofreturnn=numberofyearstomaturityPVIFA=presentvalueinterestfactorofanannuityof$1(whichcanbefoundinTable2.3)PVIF=presentvalueinterestfactorof$1(whichcanbefoundinTable2.2).Table2.3PresentValueofanAnnuityof$1(PVIFA)Years1%2%4%5%6%8%10%10.9900.9800.9620.9520.9430.9260.90921.9701.9421.8861.8591.8331.7831.73632.9412.8842.7752.7232.6732.5772.48743.9023.8083.6303.5463.4653.3123.17054.8534.7134.4524.3294.2123.9933.79165.7955.6015.2425.0764.9174.6234.35576.7286.4726.0025.7865.5825.2064.86887.6527.3256.7336.4636.2105.7475.33598.5668.1627.4357.1086.8026.2475.759109.4718.9838.1117.7227.3606.7106.145Example2.3Considerabond,maturingin10yearsandhavingacouponrateof8percent.Theparvalueis$1000.Investorsconsider10percenttobeanappropriaterequiredrateofreturninviewoftherisklevelassociatedwiththisbond.Theannualinterestpaymentis$80(8%×$1000).Thepresentvalueofthisbondisgivenbyequation(2.5):nIMV=+=I(PVIFAr,n)+M(PVIFr,n)(2.5)t=1(1+r)t(1+r)n10801000=+t=1(1=0.1)t(1+0.1)10=$80(PVIFA10%,10)+$1000(PVIF10%,10)=$80(6.145)+$1000(0.386)=$491.60+$386.00=$877.60 38EconomicsforFinancialMarketsCommonstockvaluationLikebonds,thevalueofacommonstockisthepresentvalueofallfuturecashinflowsexpectedtobereceivedbytheinvestor.Thecashinflowsexpectedtobereceivedaredividendsplusthefuturepriceatthetimeofthesaleofthestock.Foraninvestorholdingacommonstockforonlyoneyear,thevalueofthestockwouldbethepresentvalueofboththeexpectedcashdividendtobereceivedinoneyear(D1)andtheexpectedmarketpricepershareofthestockatyear-end(P1).Ifrrepresentsaninvestor’srequiredrateofreturn,thevalueofthecommonstock(P0)wouldbegivenbyequation(2.6).D1P1P0=+(2.6)(1+r)1(1+r)1Example2.4AssumeaninvestorisconsideringthepurchaseofstockAatthebeginningoftheyear.Thedividendatyear-endisexpectedtobe$1.50,andthemarketpricebytheendoftheyearisexpectedtobe$40.Iftheinvestor’srequiredrateofreturnis15percent,thenreferringtoTable2.2thevalueofthestockwouldbe:D1P1$1.50$40P0=+=+(1+r)1(1+r)1(1+0.15)(1+0.15)1=$1.50(0.870)+$40(0.870)=$1.31+$34.80=$36.11Sincecommonstockhasnomaturitydateandisheldformanyyears,amoregeneral,multiperiodmodelisneeded.Thegeneralcommonstockvaluationmodelisdefinedasfollows:∞DtP0=t=1(1+r)tTherearethreecasesofgrowthindividends:zerogrowth,constantgrowth,andsupernormalgrowth.Inthecaseofzerogrowth,ifD0=D1=...=D Thetimevalueofmoney:thekeytothevaluationoffinancialmarkets39thenthevaluationmodelbecomesDtP0=(2.7)t=1(1+r)tThisreducestoD1P0=(2.8)rExample2.5AssumingDequals$2.50andrequals10percent,thenthevalueofthestockis:$2.50P0==$250.1Inthecaseofconstantgrowth,ifweassumethatdividendsgrowataconstantrateofgeveryyear,i.e.,D=D(1+g)t,thent0equation(2.7)issimplifiedto:D1P0=(2.9)r–gThisformulaisknownastheGordongrowthmodel.Example2.6Consideracommonstockthatpaida$3dividendpershareattheendoflastyearandisexpectedtopayacashdividendeveryfutureyearwithagrowthrateof10percent.Assumethattheinvestor’srequiredrateofreturnis12percent.Thevalueofthestockwouldbe:D1=D0(1+g)=$3(1+0.10)=$3.30D1$3.30P0===$165r–g0.12–0.10Finallyconsiderthecaseofsupernormalgrowth.Firmstypi-callygothroughlifecycles,duringpartofwhichtheirgrowthisfasterthanthatoftheeconomyandthenfallssharply.Thevalueofstockduringsuchsupernormalgrowthcanbefoundbytakingthefollowingsteps: 40EconomicsforFinancialMarkets1.computethedividendsduringtheperiodofsupernormalgrowthandfindtheirpresentvalue;2.findthepriceofthestockattheendofthesupernormalgrowthperiodandcomputeitspresentvalue;and3.addthesetwopresentvaluefigurestofindthevalue(P0)ofthecommonstock.Example2.7Consideracommonstockwhosedividendsareexpectedtogrowata25percentratefortwoyears,afterwhichthegrowthrateisexpectedtofallto5percent.Thedividendpaidlastperiodwas$2.Theinvestordesiresa12percentreturn.Tofindthevalueofthisstock,takethefollowingsteps:1.Computethedividendsduringthesupernormalgrowthperiodandfindtheirpresentvalue.AssumingD0is$2,gis15percentandris12percent,then:D1=D0(1+g)=$2(1+0.25)=$2.50D=D(1+g)2=$2(1.563)=$3.12520orD2=D1(1+g))=$2.50(1.25)=$3.125D1D2PVofdividends=+(1+r)1(1+r)2$2.50$3.125=+(1+0.12)(1+0.12)2=$2.50(PVIF12%,1)+$3.125(PVIF12%,2)=$2.50(0.893)+$3.125(0.797)=$2.23+$2.49=$4.722.Findthepriceofstockattheendofthesupernormalgrowthperiod.Thedividendforthethirdyearis:D2=D2(1+g),whereg=5%=$3.125(1+0.05)=$3.28Thepriceofthestockistherefore:D3$3.28P2===$46.86r–g0.12–0.05 Thetimevalueofmoney:thekeytothevaluationoffinancialmarkets41PVofstockprice=$46.86(PVIF12%,2)=$46.86(0.797)=$37.353.AddthetwoPVfiguresobtainedinsteps1and2tofindthevalueofthestock.P0=$4.72+$37.35=$42.07SimpleinterestandcompoundinterestPresentvaluesandfuturevaluesforfinancialassetsareverysensitivetothefrequencywithwhichinterestispaid.Inparticularitisnecessarytodistinguishbetweensimpleinterestandcompoundinterest.SimpleinterestWhenmoneyofvaluePonagivendateincreasesinvaluetoSatsomelaterdate,Piscalledtheprincipal,SiscalledtheamountoraccumulatedvalueofP,andI=S–Piscalledtheinterest.Whenonlytheprincipalearnsinterestfortheentirelifeofthetransaction,theinterestdueattheendofthetimeiscalledsimpleinterest.ThesimpleinterestonaprincipalPfortyearsattheraterisgivenbyI=Prt(2.10)andthesimpleinterestamountisgivenbyS=P+I=P+Prt=P(1+rt)(2.11)Example2.8Findthesimpleintereston$750at4percentforsixmonths.Whatistheamount?1HereP=750,r=0.04,andt=2.Then1I=Prt=750(0.04)2=$15andS=P+I=750+15=$765 42EconomicsforFinancialMarketsCompoundinterestIftheinterestdueisaddedtotheprincipalattheendofeachinterestperiodandthereafterearnsinterest,theinterestissaidtobecompounded.Thesumoftheoriginalprincipalandtotalinterestiscalledthecompoundamountoraccumulatedvalue.Thedifferencebetweentheaccumulatedvalueandtheoriginalprincipaliscalledthecompoundinterest.Theinterestperiod,thetimebetweentwosuccessiveinterestcomputations,isalsocalledtheconversionperiod.Interestmaybeconvertedintoprincipalannually,semi-annually,quarterly,monthly,weekly,daily,orcontinuously.Thenumberoftimesinterestisconvertedinoneyear,orcompoundedperyear,iscalledthefrequencyofconversion.Therateofinterestisusuallystatedasanannualinterestrate,referredtoasthenominalrateofinterest.Thefollowingnotationwillbeused:Poriginalprincipal,orthepresentvalueofS,orthediscountedvalueofSScompoundamountofP,ortheaccumulatedvalueofPntotalnumberofinterest(orconversion)periodsinvolvedmnumberofinterestperiodsperyear,orthefrequencyofcompoundingjmnominal(yearly)interestratewhichiscompounded(payable,convertible)mtimesperyeariinterestrateperinterestperiod.Theinterestrateperperiod,i,equalsjm/m.Forexamplej12=12percentmeansthatanominal(yearly)rateof12percentisconverted(compounded,payable)12timesperyear,i=1%=0.01beingtheinterestratepermonth.LetPrepresenttheprincipalatthebeginningofthefirstinterestperiodanditheinterestrateperconversionperiod.Itisnecessarytocalculatetheaccumulatedvaluesattheendsofsuccessiveinterestperiodsfornperiods.Attheendofthefirstperiod,theinterestdueisPiandtheaccumulatedvalueisP+Pi=P(1+i)Attheendofthesecondperiod,theinterestdueis[P(1+i)]iandtheaccumulatedvalueisP(1+i)+[P(1+i)]i=P(1+i)(1+i)=P(1+i)2 Thetimevalueofmoney:thekeytothevaluationoffinancialmarkets43Attheendofthethirdperiod,theinterestdueis[P(1+i)2]iandtheaccumulatedvalueisP(1+i)2+[P(1+i)2]i=P(1+i)2(1+i)=P(1+i)2Continuinginthismanner,weseethatthesuccessiveaccumu-latedvalues,P(1+i),P(1+i)2,P(1+i)3,...formageometricprogressionwhosenthtermisS=P(1+i)n(2.12)whereSistheaccumulatedvalueofPattheendoftheninterestperiods.Theapplicationofcompoundinterestismostclearlyseenbyworkingthroughsomerealworldapplications.Example2.9Assumeyouareaskedtofind(a)thesimpleintereston$1000fortwoyearsat12percent,and(b)thecompoundintereston$1000fortwoyearsat12percentcompoundedsemi-annually(thatis,j2=12percent).(a)I=Prt–1000(0.12)(2)=$240(b)Sincetheconversionperiodissixmonths,interestisearnedattherateof6percentperperiod,andtherearefourinterestperiodsintwoyears,theanswercanbeseenfromTable2.4.Thecompoundinterestis$1262.48–$1000=$262.48.Alternatively,fromequation(2.12)withP=1000,i=0.06,andn=4,thenS=P(1+i)n=1000(1.06)4=$1262.48andthecompoundinterestisS–P=$262.48.Table2.4SimpleinterestversusCompoundInterestAttheInterestAccumulatedValueEndofPeriod11000(0.06)=$60$1060.0021060(0.06)=$63.60$123.6031123.60(0.06)=$67.42$1191.0241191.02(0.06)=$71.46$1262.48 44EconomicsforFinancialMarketsExample2.10Assumeyouareaskedtofindthecompoundintereston$1000at(a)j12=6percentforfiveyears,and(b)j12=15percentfor30years.(a)WehaveP=1000,i=0.06/12=0.005,andn=5×12=60.Fromequation(2.12),S=P(1+i)n=1000(1.005)60=$1348.85ThecompoundinterestisS–P=$348.85.(b)WehaveP=1000,i=0.15/12=0.0125,andn=30×12=360.Fromequation(2.12),S=1000(1.0125)360=$87,541.00ThecompoundinterestisS–P=$86,541.00,whichismorethan86timestheoriginalinvestmentof$1000.Iftheinvestmenthadbeenat15percentsimpleinterest,theinterestearnedwouldhavebeenonlyI=1000(0.15)(30)=$4500Thisillustratesthepowerofcompoundinterest.Ahighrateofinterestforalongperiodoftimegeneratesfarmorethanreceivingonlysimpleinterest.Example2.11Assumeyouareaskedtotabulateandgraphthegrowthof$100atcompoundinterestratesj12=6%,8%,10%,12%andfor5,10,15,20,25,30,35,40,45and50years(seeTable2.5andFigure2.1).Table2.5ThepowerofcompoundinterestYearsnj12=6%,j12=8%,j12=10%,j12=12%,i=0·005i=0·08/12i=0·10/12i=0·01560134.89148.98164.53181.6710120181.94221.96270.70330.0415180245.41330.69445.39599.5820240331.02492.68732.811089.2625300446.50734.021205.691978.8530360602.261093.571983.743594.9635420812.361629.263263.876530.96404801095.752427.345370.0711864.77455401478.003616.368835.4221554.69506001993.605387.8214536.9939158.34 Thetimevalueofmoney:thekeytothevaluationoffinancialmarkets451100012%10000900010%800070006000$8%5000400030006%2000100005101520253035404550YearFigure2.1Thepowerofcompoundinterest.NominalandeffectiveratesofinterestTheannualratesofinterestwithdifferentconversionperiodsarecalledequivalentiftheyyieldthesamecompoundamountattheendofoneyear.Againthisisbestunderstoodusingexamples.Example2.12Attheendofoneyearthecompoundamountof$100at:(a)4percentcompoundedquarterlyis100(1.01)4=$104.06(b)4.06percentcompoundedannuallyis100(1.0406)=$104.06.Thus4percentcompoundedquarterlyand4.06percentcompoundedannuallyareequivalentrates.Wheninterestiscompoundedmoreoftenthanonceperyear,thegivenannualrateiscalledthenominalannualrateornominalrate.Therateofinterestactuallyearnedinoneyeariscalledtheeffectiveannualrateoftheeffectiverate.InExample2.12(a),4percentisanominalratewhilein2.12(b),4.06percentisaneffectiverate.Asnotedabove,4.06percentistheeffectiverateequivalenttoanominalrateof4percentcompoundedquarterly. 46EconomicsforFinancialMarketsExample2.13Whatistheeffectiveraterequivalenttothenominalrate5percentcompoundedmonthly?Inoneyear1atreffectivewillamountto1+randat5percentcompoundedmonthlywillamountto(1+0.05/12)12.Setting1+r=(1+0.05/12)12wefindr=(1+0.05/12)12–1=1.05116190–1=0.05116190or5.116%Example2.14Whatisthenominalratejcompoundedquarterlywhichisequivalentto5percenteffective?Inoneyear1atjcompoundedquarterlywillamountto(1+j/4)4andat5percenteffectivewillamountto1.05.Setting(1+j/4)4=1.05wefind1+j/4=(1.05)1/4Thenj=4[(1.05)1/4–1]=4(0.01227223)=0.04908892or4.909% 3ThetermstructureofinterestratesandfinancialmarketsDecisionsastowhethertospendornottospend,whethertoborrow(orlend)nowortopostponeborrowing(orlending)forsixorninemonths,whethertobuysecuritiestodayorholdcashforthepresent,whetherborrowingorlendingshouldbeshort-termorlong-term,arealldecisionsinfluencedbycurrentandexpectedinterestrates.Interestratesareatthecentreofthekeyissuesinunderstandingtheeconomicsoffinancialmar-kets.Butwhatarethefactorsaffectinginterestratesandwhatexactroledointerestratesplaywithinthefinancialsystem?FunctionsofinterestratesInterestratesserveanumberofsignificantfunctions.First,theyprovideinvestorswithaguideforallocatingfundsamonginvestmentopportunities.Asfundsaredirectedintoprojectsthathavehigherexpectedratesofreturn(riskandotherfactorsbeingtakenintoaccount),thefundsareoptimallyallocatedfromtheviewpointofbothconsumerandinvestor,sincethehighestreturnsnormallyprevailwhereeffectiveconsumerdemandisstrongest.Unlessaninvestmentopportunityprom-isesareturnhighenoughtopaythemarketrateofinterest,itdoesnotjustifytherequiredcapitaloutlay.Themoneymarket,bychannellingfundsintoprojectsthathaveanexpectedreturninexcessoftheinterestrate,providesavaluableservicetoinvestors,borrowers,andsocietyasawhole.Theinterestratealsoprovidesameasureoftherelativeadvantageofcurrentconsumptioncomparedtosaving.Byadjustingtheavailablemarketrateforexpectedinflationand 48EconomicsforFinancialMarketstaxes,anindividualcandeterminetherealamountofaddi-tionalfutureconsumptionthatcanbeobtainedbypostponingcurrentconsumption.Similarly,interestrateshelpbusinessmendecideamongalternativeproductionmethods.Supposeaproductcanbemadeeithersolelywithlabourorwithacombinationoflabourandmachinery.Bycalculatingthecapitalcostofthemachine(theinterestratetimestheamountinvestedinthemachine),theexpectedlabour-plus-capitalcostcanbecomparedwiththelabour-alonecosttodeterminetheleastexpensivemeansofproduction.Determinationofinterestrates,demandandsupplyoffundsInterestratesareprices.Unlikeotherpricestheyareusuallyexpressedaspercentagesoftheamountborrowedorlent.But,likeotherprices,theyaredeterminedbysupplyanddemand.Interestratesdependonthesupplyofandthedemandforloanablefunds.Thesourcesofthesupplyoffundsaresavings,reductionsinthedemandformoneyandincreasesinthesupplyofmoney.Thesourcesofthedemandforfundsareinvestmentdemands,consumptiondemands(forspendingonconsumergoods)andincreasesinthedemandformoney.ThesupplyoffundsSaving,whichisthemainsourceofsupplyofloanablefunds,arisesinallsectorsoftheeconomyandmaytakemanyforms.Personalsaving,i.e.,theexcessofpersonalincomeoverconsumptionspending,mayconsist,interalia,ofcontributionstopensionfunds,therepaymentofmortgageloans,depositswithmutualfundsorbanks,orthepurchaseofsecurities.Businesssavingcomprisesretainedprofitsand,mostimpor-tant,depreciationcharges.Whatisnotreinvestedinthebusinessisusuallyheldinaliquidformorusedtoreducebankloans.Thegovernmentmayalsocontributetosavingintheeconomybyraisingmoreintaxesthanitneedsforitsowncurrentexpenditure;anysurplusgoestooffsetpartofthepublicsector’sowninvestment.Itisimportanttodistinguishbetweenthepotentialandtheactualsupplyofloanablefunds.Thereasonforthisisthat Thetermstructureofinterestratesandfinancialmarkets49householdsandbusinesseshavingsavingsmaynotbewillingtomakethesefundsavailabletoborrowers.Money,remem-ber,isastoreofvalue.Householdsandbusinessesmaynotwanttooffereithertheircurrentsavingsoranyoftheiraccumulatedsavingstoborrowers.Onthecontrarytheymaychoosetoaddaportionoftheircurrentsavingstotheiraccumulatedbalances.Havingmadechoicesastohowtodividetheirincomesandreceiptsbetweenspendingandsaving,householdsandbusi-nessesmustthendecideonthespecificforminwhichtoholdtheirsavings.Thebasicchoiceisbetweenmoneyintheformofeitheridlecashorbankaccountsontheonehand,andsecuritiesofsomesortontheother.Idlecashandbankaccountsarehighlyliquidassets;securitiesacquiredfromborrowersaresomewhatlessliquidbutgenerallyyieldabetterrateofreturn.Thatpartofsavings(currentoraccumulated)whichhouseholdsandbusinesseswanttoholdassecuritiesflowsintothemoneymarketasthesupplyofloanablefunds.Thatpartofsavingswhichhouseholdsandbusinesseswanttoholdascashobviouslydoesnot.Thisdivisiondependsupontheliquiditypreferencesofhouseholdsandbusinesses(i.e.,theirpreferencetoholdcashratherthanspendit).Morespecifically,therearethreemainreasonswhyhouseholdsandbusinessesprefertoholdcashratherthansecurities.1.Thereisatransactionmotiveforholdingmoneyratherthansecurities.Householdsandbusinessesbothneedastockofcashonhandtomakeordinaryday-to-daypur-chases.Households,forexample,usuallyreceiveasizeablechunkofincomeeveryweek,oreverymonth.Disburse-ments,ontheotherhand,occurmoreorlessevenlyovertime.Thismeansthathouseholdshaveanaveragemoneybalanceofsomesizebridgingthegapbetweenpaydays.Anditissimplymoreconvenienttohaveone’sassetsintheirmostliquidform,thatis,asidlecashbalancesorbankaccounts,thanintheformofsecurities.Further-more,therearecosts(brokeragefees)intransferringcashintosecuritiesandbackagain.2.Thereisaprecautionarymotiveforholdingmoney.House-holdsandbusinessesmayholdcashbalancestomeetanyrainydaycontingenciesthatmightarise.Particularlyrele-vantarethoseriskswhichonecannotprotectoneselfagainstbypurchasinginsurancepolicies,e.g.prolongedillness,unemployment,andsoforth. 50EconomicsforFinancialMarkets3.Thereisaspeculativemotiveforholdingmoney.Atanytime,thereisacertainrateofinterestthathouseholdsandbusinesses,aspotentialsuppliersofloanablefunds,con-sidertobeabout‘normal’.Iftherateofinterestiscurrentlylow,i.e.,‘belownormal’,householdsandbusinessesmaywithholdapartoftheirsavingsthatwouldotherwiseflowintothemoneymarketasapartofthesupplyofloanablefunds.Theyholdmoremoneyandfewersecuritiesthantheynormallywould.Why?Becausetheyexpectthatthecurrentbelow-normalinterestratewillprobablyriseinthefuture.Conversely,ifthecurrentinterestrateisunusuallyhigh,i.e.,‘abovenormal’,householdsandbusinesseswillchoosetoholdlessmoneyandmoresecuritiestotakeadvantageofhighcurrentinterestratesasopposedtothelowernormalrateexpectedtoprevailagaininthefuture.Thesupplyofloanablefundsiscriticallyinfluencedbythelevelofinterestrates,i.e.,higherinterest(real)rateswillinducehouseholdsandbusinesses(butobviouslynotnecessarilygovernments)tobelessliquid.Atrelativelyhighinterestrates,householdsandfirmswillprefertoholdtheirassetsintheformofinterest-bearingsecuritiesratherthanasnon-interestbear-ingcurrentaccountsandidlecashbalances.Thesupplyofloanablefundsdependson:(i)Therateofinterest.Ahighrateofinterestencouragessaverstoplacetheirfundsinfinancialinstitutionsandthesupplyofloanablefundsincreases.(ii)Theamountofsavings.Somecountries,suchasJapan,areverythrifty.Thisincreasestheamountoffundsavailableforborrowers.(iii)ABudgetsurplus.Thisoccurswhenthegovernmentspendslessthanitsrevenue.Intheseconditionsthegovernmenthasasurplusthatitcanlendtotheprivatesector.(iv)Internationalfactors.Whenforeignersbuyassetsinanothercountrytheyarelendingtothosedomesticresidents.Lowinterestratesoverseasencouragefundstoflowfromthelowinterestratecountryintothecountrieswithhigherinterestratesincreasingthesupplyoffundsavailabletoborrowersinthehighinterestratecountry(andviceversa).Thesupplycurveforloanablefundsisupwardsloping,i.e.,higherinterestratesincreasethesupplyavailable,andviceversa. Thetermstructureofinterestratesandfinancialmarkets51ThedemandforfundsNowletusturntothedemandforfunds.Againthiscanbebyprivateindividuals,companiesorgovernments.Privateindivid-ualsborrowinordertoincreasetheircurrentlevelofconsump-tioneitherforhousing,automobiles,holidaysorwhatever.Companiesborrowtopayforfactories,plantandequipment.Finally,Governmentsborrowtopayforcurrentandcapitalspending(e.g.onschools,roadsetc.whichtheycannotfinancefromtaxation).Thedemandforborrowedfundsdependson:(i)Therateofinterest.Whenitbecomesmoreexpensivetoborrow(i.e.,whentheinterestraterises)demandfromtheprivatesectorfalls(andviceversa).(ii)Thelevelofincome.Thehigherthelevelofincome,themoreindividualsandbusinesseswillwanttoborrow.Forexam-ple,ifinvestmentistoincreasefirmswillingeneralrequireoutsidefinance.Similarly,consumersborrowmoneytobuydurablegoods,washingmachines,whitegoods,etc.Moregenerallywhenincomesrise,individualsincreaseborrowingforallpurposes(houses,automobiles,etc.)andfirmsneedmoreworkingcapital.(iii)Thegovernmentfinances.Inmostcountriesgovernmentsaremajorborrowersoffunds.Thisisknownasthefiscaldeficitorbudgetdeficit(totalgovernmentexpenditureminustaxrevenue).(iv)Internationalfactors.Whenforeignersbuydomesticassetstheyarelendingtodomesticresidentsofthecountrycon-cerned.Lowoverseasinterestratesencouragedomesticbor-rowerstoborrowtheseoverseasfunds,increasingthesupplyoffundsavailabletodomesticborrowers(andviceversa).Thedemandcurveforloanablefundsisclearlydownwardsloping,i.e.,lowerinterestratesraisethedemandforfunds.Businessmenwillfinditprofitabletopurchaselargeramountsofcapitalgoodswhenthepriceofloanablefundsdeclines.Similarly,lowerinterestratesmayencouragesomeincreasesinconsumerandgovernmentborrowing.(Inpracticeitis‘real’interestrateswhicharerelevant.)Howareinterestratesdetermined?Inequilibriumtheinteractionbetweenthedemandforloanablefundsandthesupplyofloanablefundswilldeterminetheinterestrate. 52EconomicsforFinancialMarketsElementaryeconomicanalysistellsusthatifthedemandrises(I)orthesupplyfalls(II)thentheinterestraterises.Similarlyifthedemandfalls(III)orifthesupplyrises(IV)theninterestrateswillfall.ThisisillustratedinFigure3.1.Theeffectontheinterestrateofanyshiftindemandorsupplywilldependontheelasticitiesofbothsupplyanddemand.Followingachangeindemand,thelesselastic(moreelastic)isthesupplycurvethegreater(less)willbethechangeininterestrates.Followingachangeinsupply,thelesselastic(moreelastic)isthedemandcurvethegreater(less)willbetheeffectoninterestrates.PriceIISupplyIVInitialequilibriumIInterestrateDemandIIIQuantityFigure3.1Thedeterminationofinterestrates.Howcanchangesinthesupplyoffundsanddemandforfundschangeinterestrates?Ifthereismoresaving(relativetodemand)bybusinessmenandconsumers,thiswillbringdowninterestrates.Whathappensifthereisanincreaseinthesupplyofmoney?Thisaddstothesavingsinthecapitalmarket.Toseehowthiscanoccursupposethatinsteadofraisingnewfundsthroughthestockmarketcompaniesborrowfromtheirbanks,andthebanksincreasethesupplyofmoney(rememberbankloanscreatebankdepositswhichareinthemselvesthemostimportantcomponentofthemoneysupply).Becausecompaniesareborrowingfromthebanksthiswillincreasesecurityprices(duetoalowerdemand)andtherateofinterest Thetermstructureofinterestratesandfinancialmarkets53onsecuritieswillfallcorrespondinglyascompaniescannowraisefundsmorecheaply.InternationalfactorsaffectinginterestratesGiventheimportanceofinternationalfactorsinaffectinginterestratesitisworthexplaining,insomedetail,themechanicswherebyoverseasinterestratesaffectdomesticinterestrates.Thespeedoftheimpactofinternationalfactorsdependsonofficialexchangeratepolicy.Ifacountryhasafixedexchangerate(i.e.,thegovernmentiscommittedtoofficialinterventioninordertokeeptheratefixed)andthecurrencyisweak(i.e.,itisbeingheavilysoldontheforeignexchangemarket),thegovernmentmaybeinducedtoraiseofficialinterestrates.Theobjectiveistomakeitmoreattractiveforoverseasholdersofthecurrencytoholditandtomakeitlessattractivefordomesticholderstotransferitoverseas.Ifacountryhasafixedandstrongexchangeratetheremaybepressurefortheauthoritiestolowertheinterestrate.Asfundsflowintothecurrencytheauthorities,beingforcedtoincreasethedomesticmoneysupplytokeeptheexchangeratefixedwill,inanattempttoreducetheinflows,reducedomesticinterestrates.Underfloatingexchangeratestheeffectsofcapitalflowsoninterestratesoccurveryquickly.Withaweakcurrencyinvestorswillspeedilyreducetheirholdingstherebydrivingupinterestrates,e.g.bysellingbonds.ThelinkbetweenbondpricesandinterestratesmentionedinChapter2isoutlinedinmoredetailinthenextsection.Similarlyinvestorswillbekeentoacquireliabilitiesinthatcurrencysince,iftheexchangeratechangeoccursandislargerthantheextraborrowingcosttheinvestorcanrepay(sayhisbankloan)andmakeaprofit.Thecombinationofanincreaseinthesupplyofloanablefundsandadecreaseinthedemandforloanablefundsdrivesdowninterestrates.Theeffectofinternationalfactorsalsodependsonthesizeofthehomeeconomyandhowdevelopedthedomesticfinancialsystemis.Forasmalleconomyagivenforeigninflowoffundsislikelytorepresentarelativelyhighproportionofthetotalcapitalmarket.Theimpactislikelytobebiggerthereforeinacountrywithlimitedfacilitiesforforeigninvestors,forexample, 54EconomicsforFinancialMarketsbecausethecapitalmarketisundevelopedorexchangecontrolsareinoperation.Priceandyield–akeyrelationshipTheinverserelationshipbetweenpriceandyieldisimportantinunderstandinghowthefinancialsystemworks.Wheninterestratesrise,themarketpriceofoutstandingfixed-incomesecuri-ties,suchasbondsandgilts(UKgovernmentsecurities),declines.Wheninterestratesfall,themarketpriceoffixed-incomesecuritiesincreases.Holdersoffixed-incomesecuritiesthenexperiencepricedepreciationontheirportfoliosduringperiodsofrisinginterestrates.Ontheotherhandthosewhodeferthepurchaseoffixed-interestsecuritiesduringaperiodoffallinginterestrateswilllaterpayhigherprices.Thefollowingexampleillustratesthisinverserelationship.AssumethataA1000bondhasafixedcouponinterestrateof8percentandamaturitydateofperpetuity(tomakethearithmeticeasy).ThebondpaysA80ininterestperyear,andthefacevalue,orprincipalamount,isofA1000.If,sometimelater,similarbondsofcomparablematurityarepayingA90ininterestayear,bonddealerswillcontinuetobuyandsellthe8percentissue,buttheywillloweritspriceuntilitalsoyields9percent.Theprinciplebehindthisisthatnoonewouldbuyabondwithan8percentyieldwhenhecouldbuyoneofthesamequalitywitha9percentyield.Atwhatpricewillthe8percentcouponbondyielda9percentcurrentreturn?Byusingtheformulaforcurrentyield:annualinterestpaymentcurrentyield=prevailingmarketpriceandtransposingitannualinterestpaymentprevailingmarketprice=currentyieldthepricecanbedeterminedA80=A888.880.09 Thetermstructureofinterestratesandfinancialmarkets55AtapriceofA888.88,the8percentcouponbondwillyield9percent.SincethebondissellingforlessthanA1000,i.e.,lessthanparvalue,itissaidtobepricedatadiscount.Whatifmarketinterestratesfallandnewbondsarebeingsoldwith7percentcoupons?Again,the8percentcouponbondmustbebroughtintolinewithsimilarsecurities.Inthiscase,the8percentbondwillbe‘bidup’toyield7percent.A80=A1,142.860.07Sincethebondissellingformorethanpar,i.e.,A1142.86,itissaidtobepricedatapremium.Insteadoftalkingaboutthesupplyofanddemandforcreditorloanablefundsdeterminingtherateofinterest,wecouldtalkaboutthesamethingintermsofthedemandforandthesupplyofsecuritiesdeterminingthepriceofsecurities(seeFigure3.2).Tosupplycredit(lend)isequivalenttodemandingfinancialassets(securities);financialinstitutionslend,forexample,bypurchasingfinancialassets.Todemandcredit(borrow)isthesameassupplyingsecurities;businessfirmsborrowbysellingtheirbondsorotherIOUs.AtapriceofA833(whichcorre-sponds,letussay,toa6percentyield,assuminga5percentcoupononaA1000bond),relativeeagernesstobuysecurities(orlend)woulddrivethepriceofsecuritiesup,anditwoulddrivetherateofinterestdown.AndatapriceofA1250,Supplyofsecurities(borrowing)£1250Priceofsecurities£1000£833Demandforsecurities(lending)QuantityofsecuritiesFigure3.2Thedeterminationofthepriceofsecurities. 56EconomicsforFinancialMarketscorrespondingtoa4percentyield,relativeeagernesstosellsecurities(toborrow)woulddrivethepriceofsecuritiesdown,andwoulddrivetherateofinterestup.Nowletusdroptheassumptionaboutasinglerateofinterestandconsiderwhyitisthatratesofinterestoryieldsondifferentfinancialinstrumentsvary.Whydosomeborrowerspaymorethanothers?Whyaretheyieldsonlong-datedsecuritiesdifferentfromthoseonshort-datedones?Whydointerestratesondifferentcurrencydenominatedassetsvary?Itistothesequestionsthatwenowturn.ThetermstructureofinterestratesThetermstructureofinterestrates,ormaturitystructureasitissometimesreferredto,referstothesetoftheoriesdesignedtoexplainwhypracticallyhomogeneousbondsofdifferentmaturitieshavedifferentinterestrates.Thestartingpointforunderstandingthetermstructuretheoriesisthepresentvalueconcept(discussedindetailinChapter2).Becauseofthetimevalueofmoney,onedollarreceivedatafuturedatehasapresentvalueoflessthanonedollar.Ifwedenotethepresent(thatis,time0)valueof$1receivednperiodsfromnowbyDn,thentheinterestrateisthediscountrate(denotedbyRn)thatsolvesthefollowingequation.1Dn=(3.1)(1+R)nnDnrepresentsboththepresentvalueof$1receivedinnperiodandthespotpriceofazerocouponbondwithaparvalueof$1.ThepurchaserofthiszerocouponbondpaysthepurchasepriceDnattimezeroandreceivestheparvalueof$1attimen.TherateRniscalledthezerocoupondiscountrateorthespotinterestrate.Thespotmarketisthemarketforimmediatedelivery.Someobserverscallthespotmarketthe‘cash’market.ThespotpriceDnandthespotinterestrateRnareinverselyrelated.Whenthespotinterestrategoesup,thespotpricegoesdownbecausethespotinterestrateisthedenominator.Asthespotinterestrateincreases,thedenominatorincreases,andtheratio(thatis,theprice)decreases.Figure3.3andTable2.2 Thetermstructureofinterestratesandfinancialmarkets57PriceSpotrateFigure3.3Spotpriceversusspotinterestrate.illustratethispoint.LookacrossanyrowofTable2.2.Asyoumovetotheright,theinterestrateincreasesandthepresentvaluedecreases.InTable2.2thepresentvaluedecreasesasmaturityincreasesforagiveninterestrate.Toseethispoint,lookdownanycolumnofTable2.2.Thelowestpresentvaluesareinthelowerrightcornerofthetableforlongmaturitiesandhighinterestrates.ConsidertheexamplesinFigure3.4.Thespotinterestrateis8percentforoneperiod,10percentfortwoperiods,and12percentforthreeperiods.D1equals0.93,whichmeansthatthepresentvalueof$1receivedoneperiodfromnowis$0.93.D2is0.83,whichmeansthatthepresentvalueof$1receivedtwoperiodsfromnowis$0.83.Thepresentvalueof$1receivedthreeperiodsfromnow,D3,is$0.71.Pointsintime01231$1D=0.93=11.081D=0.83=22$1(1.10)1D=0.71=33$1(1.12)Figure3.4Presentvalues. 58EconomicsforFinancialMarketsThepatternofspotinterestratesfordifferentmaturitiesiscalledthetermstructureofinterestrates.DeterminationofforwardinterestratesAssumetheone-yearspotinterestrateforariskfreesecuritywasdeterminedtobe7percent.Thismeansthatthemarkethasdeterminedthatthepresentvalueof$1tobepaidbytheUnitedStatesTreasuryinoneyearis$1/1.07or$0.9346.Thatmeansthattherelevantdiscountrateforconvertingacashflowoneyearfromnowtoitspresentvalueis7percent.Ifthetwo-yearspotinterestratewas8percent,thepresentvalueof$1tobepaidbytheUSTreasuryintwoyearsis$1/1.082,or$0.8573.(YouareadvisedtocheckthiswithTable2.2.)Analternativeviewof$1tobepaidintwoyearsisthatitcanbediscountedintwosteps.Thefirststepdeterminesitsequivalentone-yearvalue.Thatis,$1tobereceivedintwoyearsisequivalentto$1/(1+f1,2)tobereceivedinoneyear.Thesecondstepdeterminesthepresentvalueofthisequivalentone-yearamountbydiscountingitattheone-yearspotinterestrateof7percent.Thusitscurrentvalueisgivenby:$1/(1+f1,2)(3.2)(1+0.07)However,thisvaluemustbeequalto$0.8573as,accordingtothetwo-yearspotrate(asmentionedearlier),$0.8573isthepresentvalueof$1tobepaidintwoyears.Thatis,$1/(1+f1,2)=$0.8573(1+0.07)whichhassolutionforf1,2of9.01percent.Thisdiscountratef1,2isknownastheforwardratefromyearonetoyeartwo.Thatis,thediscountratefordeterminingtheequivalentvalueoneyearfromnowofadollarthatistobereceivedtwoyearsfromnow.Intheexample,$1tobereceivedtwoyearsfromnowisequivalentinvalueto$1/1.0901=$0.9174tobereceivedoneyearfromnow(notethatthepresentvalueof$0.9174is$0.9174/1.07=$0.8573). Thetermstructureofinterestratesandfinancialmarkets59TheyieldcurveAnotherimportanttermitisimportanttobefamiliarwithistheyieldcurve.Ayieldcurveisagraphthatshowstheyields-to-maturity(ontheverticalaxis)foridenticalsecuritiesofvarioustermstomaturity(onthehorizontalaxis)asofaparticulardate.Inordertoeliminatetheriskofdefaultthecalculationsarenormallydoneforrisk-free,government-issuedsecurities.Theshapeoftheyieldcurveprovidesanestimateofthecurrenttermstructureofinterestratesandwillchangeasyieldstomaturitychange.Figure3.5illustratesthemostcommonlyobservedyieldcurves.(a)Upwardsloping(b)Flat(c)DownwardslopingYieldYieldYieldMaturityMaturityMaturityFigure3.5Yieldcurves.Fourprimarytheoriesareusedtoexplainthetermstruc-tureofinterestrates:theunbiasedexpectationstheory,theliquiditypreferencetheory,themarketsegmentationtheory,andthepreferredhabitattheory.Indiscussingthem,thefocuswillbeonthetermstructureofspotinterestrates,becausetheseratesarecriticallyimportantindeterminingthepriceofanyriskfreesecurity.Sharpe,AlexanderandBailey(1999)provideanexcellenttermstructuresurveyandthishasbeendrawnuponhere.UnbiasedexpectationstheoryTheunbiasedexpectationstheory(orpureexpectationstheory,asitissometimescalled)holdsthattheforwardraterepresentstheaverageopinionofwhattheexpectedfuturespotrateforthe 60EconomicsforFinancialMarketsperiodinquestionwillbe.Soasetofspotinterestratesthatisrisingcanbeexplainedbyarguingthatthemarketplace(thatis,thegeneralopinionofinvestors)believesthatspotinterestrateswillberisinginthefuture.Conversely,asetofdecreasingspotinterestratesisexplainedbyarguingthatthemarketplaceexpectsspotinterestratestofallinthefuture.Upward-slopingyieldcurvesInordertounderstandthistheorymorefully,consideranexampleinwhichtheone-yearspotratewas7percentandthetwo-yearspotratewas8percent.Thebasicquestionisthis:Whyarethesetwospotinterestratesdifferent?Equivalently,whyistheyieldcurveupwardsloping?Consideraninvestorwith$1toinvestfortwoyears.Thisinvestorcouldfollowa‘maturitystrategy’,investingthemoneynowforthefulltwoyearsatthetwo-yearspotinterestrateof8percent.Withthisstrategy,attheendoftwoyearsthedollarwillhavegrowninvalueto$1.1664(=$1×1.08×1.08).Alternatively,theinvestorcouldinvestthedollarnowforoneyearattheone-yearspotinterestrateof7percent,sothattheinvestorknowsthatoneyearfromnowtheinvestorwillhave$1.07(=$1×1.07)toreinvestforonemoreyear.Althoughtheinvestordoesnotknowwhattheone-yearspotratewillbeoneyearfromnow,theinvestorhasanexpectationaboutwhatitwillbe.Theexpectedfuturespotinterestratewillhereafterbedenotedases1,2.Iftheinvestorthinksthatitwillbe10percent,thenthe$1investmenthasanexpectedvaluetwoyearsfromnowof$1.177(=$1×1.07×1.10).Inthiscase,theinvestorcouldchoosea‘rolloverstrategy’,meaningthatheorshewouldchoosetoinvestinaone-yearsecurityat7percentratherthaninthetwo-yearsecurity,becauseonewouldexpecttohavemoremoneyattheendoftwoyearsbydoingso,giventhat$1.177>$1.1664.However,anexpectedfuturespotinterestrateof10percentcannotrepresentthegeneralviewinthemarketplace.Ifitdid,investorswouldnotbewillingtoinvestmoneyatthetwo-yearspotinterestrate,asahigherreturnwouldbeexpectedfrominvestingmoneyattheone-yearrateandusingtherolloverstrategy.Sothetwo-yearspotinterestratewouldquicklyriseasthesupplyoffundsfortwo-yearloansat8percentwouldbelessthanthedemand.Conversely,thesupplyoffundsforoneyearat7percentwouldbemorethanthedemand,causingtheone-yearspotratetofallquickly.Thus,aone-yearspotinterest Thetermstructureofinterestratesandfinancialmarkets61rateof7percent,atwo-yearspotinterestrateof8percent,andanexpectedfuturespotinterestrateof10percentcannotrepresentanequilibriumsituation.Butnowwhatiftheexpectedfuturespotinterestrateoneyearaheadis6percentinsteadof10percent?Inthiscase,accordingtotherolloverstrategytheinvestorwouldexpect$1tobeworth$1.1342(=$1×1.07×1.06)attheendoftwoyears.Thisislessthanthevaluethe$1willhaveifthetwoyearinvestmentstrategyisfollowedgiventhat$1.1342<$1.664,sotheinvestorwouldchoosethetwo-yearinvestmentperiodstrategy.Again,however,anexpectedfuturespotinterestrateof6percentcannotrepresentthegeneralviewinthemarketplacebecauseifitdid,investorswouldnotbewillingtoinvestmoneyattheone-yearspotinterestrate.Weshowedabove(page58)thattheforwardrateinthisexamplewas9.01percent.Whatiftheexpectedfuturespotinterestratewasofthismagnitude?Attheendoftwoyearsthevalueof$1withtherolloverstrategywouldbe$1.1664(=$1×1.07×1.0901),thesameasthevalueof$1withthetwo-yearinvestmentperiodstrategy.Inthiscase,equilibriumwouldexistinthemarketplacebecausethegeneralviewwouldbethatthetwostrategieshavethesameexpectedreturn.Accordingly,investorswithatwo-yearholdingperiodwouldnothaveanincentivetochooseonestrategyovertheother.Theunbiasedexpectationstheoryassertsthattheexpectedfuturespotrateisequalinmagnitudetotheforwardrate.Intheexample,thecurrentone-yearspotrateis7percent,and,accordingtothistheory,thegeneralopinionisthatitwillrisetoarateof9.01percentinoneyear.Thisexpectedriseintheone-yearspotrateisthereasonbehindtheupward-slopingtermstructurewherethetwo-yearspotrate(8percent)isgreaterthantheone-yearspotrate(7percent).EquilibriumInequationform,theunbiasedexpectationstheorystatesthatinequilibriumtheexpectedfuturespotinterestrateisequaltotheforwardrate:es1,2=f1,2(3.3)Thepreviousexampledealtwithanupward-slopingtermstructure;thelongertheterm,thehigherthespotinterestrate.Whereastheexplanationforanupward-slopingtermstructure 62EconomicsforFinancialMarketswasthatinvestorsexpectspotratestoriseinthefuture,thereasonforthedownward-slopingcurveisthatinvestorsexpectspotinterestratestofallinthefuture.LiquiditypreferencetheoryTheliquiditypreferencetheorystartswiththenotionthatinvestorsareprimarilyinterestedinpurchasingshort-termsecurities.Thatis,eventhoughsomeinvestorsmayhavelongerholdingperiods,thereisatendencyforthemtoprefershort-termsecurities.Theseinvestorsrealizethattheymayneedtheirfundsearlierthananticipatedandrecognizethattheyfaceless‘interestraterisk’iftheyinvestinshorter-termsecurities.InterestrateriskInvestorswithatwo-yearholdingperiodwouldtendtoprefertherolloverinvestmentstrategybecausetheywouldbecertainofhavingagivenamountofcashattheendofoneyearwhenitmaybeneeded.Aninvestorwhofollowedatwo-yearinvestmentstrategywouldhavetosellthetwo-yearsecurityafteroneyearifcashwereneeded.However,itisnotknownnowwhatpricethatinvestorwouldgetforthetwo-yearsecurityinoneyear.Thusthereisanextraelementofriskassociatedwiththetwo-yearinvestmentstrategythatisabsentfromtherolloverstrategy.Theupshotisthatinvestorswithatwo-yearholdingperiodwillnotchoosethetwo-yearinvestmentstrategyifithasthesameexpectedreturnastherolloverstrategybecauseitisriskier.Theonlywayinvestorswillfollowthetwo-yearinvest-mentstrategyandbuythetwo-yearsecuritiesisiftheexpectedreturnishigher.Thatisborrowerswillhavetopaytheinvestorsariskpremiumintheformofagreaterexpectedreturninordertogetthemtopurchasetwo-yearsecurities.Willborrowersbeinclinedtopaysuchapremiumwhenissuingtwo-yearsecurities?Yes,theywill,accordingtotheliquiditypreferencetheory.First,frequentrefinancingmaybecostlyintermsofregistration,advertisingandpaperwork.Thesecostscanbelessenedbyissuingrelativelylong-termsecurities.Second,someborrowerswillrealizethatrelativelylong-termbondsarealessriskysourceoffundsthanrelativelyshort-termfundsbecauseborrowerswhousethemwillnothavetobeasconcernedaboutthepossibilityofrefinancinginthefutureat Thetermstructureofinterestratesandfinancialmarkets63higherinterestrates.Thusborrowersmaybewillingtopaymore(viahigherexpectedinterestcosts)forrelativelylong-termfunds.Intheearlierexample,theone-yearspotinterestratewas7percentandthetwo-yearspotinterestratewas8percent.Accordingtotheliquiditypreferencetheory,theonlywayinvestorswillagreetofollowatwo-yearinvestmentstrategyisiftheexpectedreturnfromdoingsoishigherthantheexpectedreturnfromfollowingtherolloverstrategy.Sotheexpectedfuturespotratemustbelessthantheforwardrateof9.01percent.Assumeitis8.6percent.At8.6percentthevalueofa$1investmentintwoyearsisexpectedtobe$1.1620(=$1×1.07×1.086),iftheroll-overinvestmentstrategyisfollowed.Becausethevalueofa$1investmentwiththetwo-yearinvestmentstrategyis$1.1664(=$1×1.08×1.08),itcanbeseenthatthetwo-yearinvestmentstrategyhasahigherexpectedrateofreturnforthetwo-yearperiodthancanbeattributedtoitsgreaterdegreeofrisk.LiquiditypremiumtheoryThedifferencebetweentheforwardrateandtheexpectedfuturespotinterestrateisknownastheliquiditypremium.Itisthe‘extra’returngiventoinvestorsinordertoenticethemtopurchasetheriskierlonger-maturitytwo-yearsecurity.Intheexamplegivenearlier,itisequalto0.41percent(=9.01–8.6percent).Moregenerallyitisgivenby:f1,2=es1,2+L1,2(3.4)whereL1,2istheliquiditypremiumfortheperiodstartingoneyearfromnowandendingtwoyearsfromnow.Sohowdoestheliquiditypreferencetheoryexplaintheslopeofthetermstructure?Inordertoanswerthisquestion,notethatwiththerolloverinvestmentstrategytheexpectedvalueofadollarattheendoftwoyearsis$1×(1+s1)×(1+es1,2).Alternativelywiththetwoyearinvestmentstrategy,theexpectedvalueofadollarattheendoftwoyearsis$1×(1+s)2.According2totheliquiditypreferencetheory,thereismoreriskwiththetwo-yearinvestmentstrategy,whichinturnmeansthatitmusthaveahigherexpectedreturn.Thatis,thefollowinginequality,showninthefollowingequations,musthold:$1(1+s)×(1+es)<$1(1+s)2(3.5)11,22or:(1+s)×(1+es)<(1+s)2(3.6)11,22 64EconomicsforFinancialMarketsThisinequalityisthekeytounderstandinghowtheliquiditypreferencetheoryexplainsthetermstructure.Downward-slopingyieldcurvesConsiderthedownward-slopingcasefirst,wheres1>s2.Theaboveinequalitywillholdinthissituationonlyiftheexpectedfuturespotinterestrate(es1,2)issubstantiallylowerthanthecurrentone-yearspotinterestrate(s1).Thusadownward-slopingyieldcurvewillbeobservedonlywhenthemarketplacebelievesthatinterestratesaregoingtodeclinesubstantially.Asanexample,assumethattheone-yearspotinterestrate(s1)is7percentandthetwo-yearspotinterestrate(s2)is6percent.Because7percentisgreaterthan6percent,thisisasituationinwhichthetermstructureisdownwardsloping.Nowaccordingtotheliquiditypreferencetheory,equation(3.6)indicatesthat,(1+0.07)(1+es)<(1.06)21,2whichcanbetrueonlyiftheexpectedfuturespotrate(es1,2)issubstantiallylessthan7percent.Giventheone-yearandtwo-yearspotinterestrates,theforwardrate(f1,2)isequalto5.01percent.Assumingtheliquiditypremium(L1,2)is0.41percent,then,accordingtoequation(3.4)es1,2mustbe4.6percent(=5.01–0.41percent).Thus,thetermstructureisdownwardslopingbecausetheone-yearspotinterestrateof7percentisexpectedtodeclineto4.6percentinthefuture.Theunbiasedexpectationstheorywouldalsoexplainthetermstructurebysayingitwasdownward-slopingbecausetheone-yearspotratewasexpectedtodeclineinthefuture.However,theunbiasedexpectationstheorywouldexpectthespotratetodeclineonlyto5.01percent,notto4.6percent.FlatyieldcurveConsidernextthecaseofaflatyieldcurve,wheres1=s2.Equation(3.6)willbetrueinthissituationonlyifes1,2islessthans1.Thusaflattermstructurewilloccuronlywhenthemarketplaceexpectsspotinterestratestodecline.Indeed,ifs1=s2=7percentandL1,2=0.41percent,thenf1,2=7percent,and,accordingtoequation(3.4),theexpectedfuturespotrateis6.59percent(=7.00–0.41percent),adeclinefromthecurrent Thetermstructureofinterestratesandfinancialmarkets65one-yearspotrateof7percent.Thisoutcomeisincontrasttotheunbiasedexpectationstheory,whichwouldinterpretaflatratestructuretomeanthatthemarketplaceexpectedinterestratestoremainatthesamelevel.Upward-slopingyieldcurvesThelastcaseisanupward-slopingyieldcurvewheres1RETA=(pointD)=9.5thenthemarketwillbuy$/selleurosandtheeffectisthatthedollarrises/eurofalls.Whydoexchangerateschange?Theychangesothattheexchangeratesettlesattheinter-sectionofRETAandRET$.Naturallyifeitheroftheseexpectedreturnschedulesshiftthensowilltheexchangerate.Letusexaminetheeffectsofthesechangesinturn. 216EconomicsforFinancialMarketsShiftsinexpectedreturnscheduleforforeigndepositsEarlierweestablishedthat(Ee–E)t+1tRETA=iA–EtAchangeinEtwillresultinamovementalongtheexpectedreturnscheduleforeuros.Factorsthatshiftthewholeschedulewillbetheremainingtermsinthisformula,namelytheforeigninterestrateiAandtheexpectedfutureexchangerate.Changesintheforeigninterestrate(iA)IfiArisestheRETAalsorises.InFigure9.7RETAmovesto1RETA.ThedollarfallsfromEtoEasinvestorsselleuros212andbuydollars.Naturallyififalls,RETAmovestotheleftandAthedomesticcurrency,thedollar,appreciatesandtheeurodepreciates.ChangesintheexpectedfutureexchangerateEet+1IfthefutureexchangerateofthedollarisexpectedtofallthisdecreasestheexpectedappreciationofthedollarandhenceERET$RET
t1RET
2E11E22Exchangerateeuro/$1$Expectedreturn(in$terms)Figure9.7Changesintheforeigninterestrate. Whyareexchangeratessovolatile?217raisestheexpectedreturnineuros,movingfromRETAto1RET2A.ThedollarfallsfromE1toE2.Anexpectationthatthedollarwillriseshiftstheschedulewiththedollarrisingandtheeurofalling.Ontheotherhand,ariseinEeraisestheexpectedt+1appreciationofthedollar,lowerstheexpectedreturnoneurodeposits,shiftstheRETAscheduletotheleft,andraisestheexchangerate.Tosummarize:ariseintheexpectedfutureexchangerateshiftstheexpectedreturnonforeign(euro)depositsscheduletotheleftandcausesanappreciationofthedomesticcurrency(dollar).AfallintheexpectedfutureexchangerateshiftstheRETAscheduletotherightandcausesadepreciationofthedomesticcurrency(dollar).ShiftsintheexpectedreturnschedulefordomesticdepositsSincetheexpectedreturnondomestic(dollar)depositsisjusttheinterestrateonthesedeposits,i$,thisinterestrateistheonlyfactorthatshiftstheexpectedreturnonthedollardepositsschedule.ThiscanbeseenfromFigure9.8.Shiftsintheexpectedreturnondomesticdepositsschedule(RET$).Anincreaseintheexpectedreturnondollardeposits(i$),ERET$RET$t12RET
1E12E21Exchangerateeuro/$i$i$12Expectedreturn(in$terms)Figure9.8Changesintheexpectedreturnscheduleforforeigndeposits. 218EconomicsforFinancialMarketsshiftstheexpectedreturnondomestic(dollar)depositsfromRET$toRET$andtheexchangeratefallsfromEtoE.1212Changesinthedomesticinterestrate(i$)Ariseini$raisestheexpectedreturnondollardeposits,shiftstheRET$scheduletotheright,andleadstoariseintheexchangerate,asshowninFigure9.8.Anotherwayofseeingthisistorecognizethatariseini$,whichraisestheexpectedreturnondollardeposits,createsanexcessdemandfordollardepositsattheoriginalequilibriumexchangerate,andtheresultingpurchasesofdollardepositscausesanappreciationofthedollar.Ariseinthedomesticinterestrate(i$)shiftstheexpectedreturnondomesticdepositstotherightandcausesanappreciationofthedomestic(dollar)currency:afallini$shiftstheRET$scheduletotheleftandcausesadepreciationofthedollar.Ourearlieranalysisofthelong-rundeterminantsoftheexchangerateindicatedthatthefactorsthatinfluencetheexpectedfutureexchangerateare:therelativepricelevel,relativetariffsandquotas,importdemand,exportdemand,andrelativeproductivity.ThetheoryofpurchasingpowerparitysuggestthatifahigherAmericanpricelevelrelativetotheforeignpricelevelisexpectedtopersist,thedollarwilldepreciateinthelongrun.AhigherexpectedrelativeAmericanpricelevelshouldthushaveatendencytoraisetheexpectedreturnoneurodeposits,shifttheRETAscheduletotheright,andlowerthecurrentexchangerate.Similarlytheotherlong-rundeterminantsoftheexchangeratewediscussedearliercanalsoinfluencetheexpectedreturnoneurodepositsandthecurrentexchangerate.Brieflythefollowingchangeswillincreasetheexpectedreturnoneurodepositsandthecurrentexchangerate.Thefollowingchangeswillincreasetheexpectedreturnoneurodeposits,shifttheRETAscheduletotheright,andcauseadepreciationofthedomesticcurrency,thedollar.ExpectationsofariseintheAmericanpricelevelrelativetotheforeignpricelevel;ExpectationsoflowerAmericantariffsandquotasrelativetoforeigntariffsandquotas;ExpectationsofhigherAmericanimportdemand;ExpectationsoflowerforeigndemandforAmericanexports;and Whyareexchangeratessovolatile?219ExpectationsoflowerAmericanproductivityrelativetoforeignproductivity.TheseeffectsaresummarizedinTable9.2.Whyareexchangeratessovolatile?Theanswertothisquestionisprovidedbytheassetmarketapproachtoexchangeratedeterminationoutlinedabove.Becauseanexpectedappreciationofthedomesticcurrencyaffectstheexpectedreturnonforeigndeposits,thenexpecta-tionsaboutthepricelevel,inflation,tariffsandquotas,productivity,importdemand,exportdemand,andthemoneysupplyplayanimportantroleindeterminingtheexchangerate.Whenexpectationsaboutanyofthesevariableschange,therewillbeanimmediateeffectontheexpectedreturnofforeigndepositsandthereforeontheexchangerate.Sinceexpectationsonallthesevariableschangewithjustabouteverybitofnewsthatappearsitisnotsurprisingthatexchangeratesaresovolatile.SeeKettell(1998,1999,2000)fordetailsofexactlywhichnewsmovesthecurrencymarkets.AnillustrationoftheeffectofchangingtheassumptionsaboutthefactorsappliedintheassetmarketapproachisgiveninTable9.3.Incase1theinterestdifferentialinfavourofdollardepositsis4percentperyear(i$–iA=0.10–0.06=0.04)andatthesametimenochangeintheexchangerateisexpected[(Ee–E)/E=t+1tt0.00].Thismeansthattheexpectedannualrealrateofreturnondollardepositsis4percenthigherthanthatoneurossothat,otherthingsequal,investorswouldpreferdollarsratherthaneurodeposits.Incase2,theinterestdifferentialisthesame(4percent),butitisjustoffsetbyanexpecteddepreciationrateofthedollarof4percent.Thetwoassetsthereforehavethesameexpectedrateofreturn.Incase3,a4percentinterestdifferentialinfavourofdollardepositsismorethanoffsetbyan8percentexpecteddepreciationofthedollar,soeurodepositsarepreferredbymarketparticipants. 220EconomicsforFinancialMarketsTable9.2FactorsthatShifttheRETeandRET$schedulesandcauseexchangeratestochangeFactorChangeResponseofInFactorExchangeRate,EtRET1$RET2$EtRET$E2Domesticinterestrate,i$↑↑E1RETin$RET$RET
E1tRET
2E1Foreigninterestrate,ie↑↓E2RETin$RET$RET
E1tRET
2E1Expecteddomesticpricelevel*↑↓E2RETin$RET$RET
E2tRET
1E2Expectedtariffsandquotas*↑↑E1RETin$RET$RET
E1tRET
2E1Expectedimportdemand↑↓E2RETin$RET$RET
E2tRET
1E2Expectedexportdemand↑↑E1RETin$RET$RET
E2tRET
1E2Expectedproductivity↑↑E1RETin$Source:AdaptedfromMishkinandEakinsFinancialMarketsandInstitutions.AddisonWesley,1998.Note:Onlyincreases(↑)inthefactorsareshown;theeffectsofdecreasesinthevariablesontheexchangeratearetheoppositeofthoseindicatedinthethirdcolumn. Whyareexchangeratessovolatile?221Table9.3ComparingratesofreturnondollarandeurodepositsCaseDollarEuroExpectedrateRateofreturninterestinterestofdollardifferencerate(%)rate(%)depreciationbetweendollaragainstandeuroeuro(%)deposits(%)Ee–EEe–Et+1tt+1ti$iAi$–iA+EtEt10.100.060.000.0420.100.060.040.0030.100.060.08–0.0440.100.12–0.040.02Source:AdaptedfromMishkinandEakinsFinancialMarketsandInstitutions.AddisonWesley,1998.Incase4,thereisa2percentinterestdifferentialinfavourofeurodeposits,butthedollarisexpectedtoappreciateagainsttheeuroby4percentovertheyear.Theexpectedrateofreturnondollardepositsistherefore2percentperyearhigherthanthatoneuros,sodollardepositsarepreferredbymarketparticipants. 10HowcaninvestorspredictthedirectionofUSinterestrates?Whatdo‘Fedwatchers’watch?A‘Fedwatcher’isaneconomistwhospecializesinpredictingandanalysingtheactionsoftheFederalReserve,theUScentralbank.TheytrytounderstandthebasicthrustofpolicyandtodetectanysignsthatobjectivesarechangingbypredictingthevariablesthattheFederalReservefollowsandanticipatingfuturepolicydevelopments.InparticulartheFedwatchertrackstheFederalOpenMarketCommittee(FOMC),theactivitiesoftheFedopenmarketdeskattheFederalReserveBankofNewYork,andthebehaviouroftheeconomyoverall.WehavesetoutbelowsomerulesofthumbthataFedwatchershouldapply.Aswithanyrule-of-thumbapproachtheserulesmustbeadaptedasthecircumstancesdemand.GiventhattheFOMCplayssuchacentralroleindeterminingthepathofUSinterestrates,towardstheendofthechapterwediscusstheproblemof‘decoding’theFOMCminutes.Table10.1setsoutthegoldenrulesforFedwatching.Rule1:rememberthecentralroleofnominal/realGNPquarterlygrowthTheFedwatchermustprojectandinterpretdevelopmentsotherthanFederalReservepolicythatarelikelytoaffect HowcanyoupredictthedirectionofUSinterestrates?223Table10.1FEDWatchingRulesRule1Rememberthecentralroleofnominal/realGNPquarterlygrowth.Rule2Tracktheshapeoftheyieldcurveifyouwanttopredictbusinesscycleturningpoints.Rule3WatchwhattheFedwatches–notwhatyouthinkitshouldwatch.Rule4Keepaneyeonthe3-montheurodollarfuturescontract.Rule5UsetheTaylorruleasaguidetochangesinFedpolicy.Rule6PayattentiontowhattheFeddoes–nottowhatitsays.Rule7ViewpotentialFedpolicyshiftsasareactiontoratherthanacauseofundesiredeconomic/monetaryconditions.Rule8RememberthatultimatelytheFedisacreatureofcongress.Rule9FollowthetrendsinFOMCdirectives.Rule10Fearsofinflationprovokefasterchangesinmonetarypolicythandofearsofunemployment.futureeconomicconditionsandinterestrates.AFedwatcherwillproduceadvanceestimatesofkeyeconomicstatisticstogivemarkettradersabenchmarkforevaluatingthestatisticswhentheyarereleased.Statisticspublishedmonthlyontheeconomy,e.g.retailsales,production,employment,andpri-ces,areallforecast.Therearefashionsinwhatdatareceivethemostattention,someofwhichwerediscussedinChapters5,6,and7.WhenevertheFederalReserveisperceivedtobeshiftingitsfocus,marketattentionandforecastingeffortsshiftaswell.Toforecasteconomicbehaviour,financialeconomistsexam-inerecenttrendsandconsidercomponentsthatmightbechanging.Someanalystsmakecomprehensiveforecastsofthesupplyanddemandforfundsassociatedwithdifferentsectorsoftheeconomy,e.g.consumer,business,governmentandforeign.Themodellinginvolvedreliesheavilyonbothindividualjudgementandeconometrictechniques.Thesemi-annualHumphrey–HawkinsTestimonysetsouttheFederalReservecentraltargetsandprojectionsfornominalGDP,realGDPandthePersonalConsumerExpenditure(PCE)PriceIndex.Toillustratethis,theeconomicprojectionsfor2002aresetoutinTable10.2.IfthenominalGDPgrowthappearstobeovershootingthetargetthereispressurefortheFedfundsratetorise.Similarly 224EconomicsforFinancialMarketsTable10.2Economicprojectionsfor2002PercentIndicatorFederalReservegovernors’andChangefourthquarterReserveBankpresidentstofourthquarterRangeCentraltendencyNominalGDP43–65–5142RealGDP3–313–3124PCEprices11–313–21242Civilianunemploymentrate43–5143–514244Source:Humphrey–HawkinsTestimony2001ifthereappearstobeundershootingthereispressurefortheFedfundsratetofall.ThejobofaFedwatcheristotracktheeconomiccyclewithaviewtoprojectingthenextquarterGDPgrowthandthustohavesomeviewastothelikelytrendofinterestrates.ReadtheBeigeBookBoardsofDirectorsoftheReserveBanksandbranchesprovidetheFederalReserveSystemwithawealthofinformationoneconomicconditionsinvirtuallyeverycorneroftheUnitedStates.ThisinformationisusedbytheFOMCandtheBoardofGovernorsinreachingmajordecisionsaboutmonetarypolicy.InformationfromdirectorsandothersourcesgatheredbytheReserveBanksisalsosharedwiththepublicinaspecialreport(informallycalledtheBeigeBook)whichisissuedabouttwoweeksbeforeeachmeetingoftheFOMC.TheBeigeBook,calledthisbecauseofthecolour,providesausefulsummaryofthecurrentstateoftheeconomyrepresent-ingtheregionsofthe12reportingbanks.ItisthisbroadrepresentationandcoveragethatisitsgreatstrengthandthereasonwhytheFOMCwillanalyseitcarefully.AtypicalscheduleofpublicationispublishedannuallyandtheschedulefollowstheformatofTable10.3.TheFOMCwillalsohaveaccesstotheGreenBookandtheBlueBook.TheGreenBookprovidesananalysisofdomesticeconomicindicatorsandprojections,whilsttheBlueBookexaminesthemonetarypolicyoptionsofthestatusquo,easingortightening.FromaFedwatcherspointofviewtheseareunhelpfulastheyareonlypublishedafterafive-yeartimelag. HowcanyoupredictthedirectionofUSinterestrates?225Table10.3Keydatesin2002BeigeBookReleasedFOMCMeetingsReleaseofMinutesJanuary15January29/30ThesearemadeavailableMarch7March19withinafewdaysaftertheApril26May7nextregularlyscheduledJune13June25/26meeting.July23August13September10September24October24November6November28December10Rule2:tracktheyieldcurveifyouwanttopredictbusinesscycleturningpointsEconomistsoftenusecomplexmathematicalmodelstoforecastthepathoftheUSeconomyandthelikelihoodofrecession.Butsimplerindicatorssuchasyieldcurves,definedbelowalsocontainvaluable,simpletoanalyse,insightsintolikelyfutureeconomicactivity.Historicalexperienceshowsthatonseveraloccasionspriortorecessions,long-terminterestratesdippedbelowprevailingshort-termrates,aphenomenonknownasaninvertedornegativeyieldcurve.Since1960theyieldcurvehasbeeninvertedpriortoallfiverecessions.Theextenttowhichtheyieldcurveistiltedawayfromitsnormal‘shape’hasbeenidentifiedbymanyresearchersasavaluableindicatorofforthcomingrecession.Itiswellunderstoodthatthemacroeconomiceffectsofmonetarypolicyoccurwithsignificantlags.Consequently,havinganearlypredictorofeconomicdevelopmentsisusefulinhelpingmonetaryauthoritiestodeterminetheappropriatepolicystance.Ithasbeenrecognizedforsometimethattheyieldcurve,whichshowsthetermstructureofinterestratesprevailinginaneconomyatanypointintime,containsinformationthatcanbeusedasanindicatorofeconomicprospects.Thisisbecausethetermstructurereflectsboththesettingsoftheinstrumentsofmonetarypolicy,asshownin 226EconomicsforFinancialMarketsthelevelofshort-terminterestrates,andthemarket’sexpec-tationoffutureshort-termrates,andhenceoffuturegrowthandinflation.Aneasingofmonetaryconditions,byloweringshort-termrates,willbothtendtosteepenanormallyupward-slopingyieldcurveandraiseprospectivegrowthandinflation.Theoppositewouldoccurforatighteningofmonetaryconditions.Similarly,ashiftinmarketexpectationstowardhigherinflationorgrowth,forgivensettingsofshort-terminterestrates,willtendtoraiselong-termratesandsteepentheyieldcurve.Thedifferencebetweenlong-termandshort-termratescanoftenbeausefulleadingindicatorofmacroeconomicdevelopments.Toappreciatetheimportanceofyieldcurveswemustfirstturntothetheoryandthentotheempiricalevidence.Whatisthetheorybehindtheshapeoftheyieldcurve?Monetarypolicyworksmostdirectly,asdiscussedinearlierchapters,bychangingreserveavailability.SuchchangesaffecttheovernightFedfundsrateandothershort-termrates,whichinturnaffectthemonetaryaggregates.Expectationsoffutureinterestratesinfluencetheshapeoftheyieldcurveaslongaspotentialinvestorsandborrowershavechoicesaboutthematurityoftheinstrumentstheypurchaseorissue.Forinstance,potentialinvestorscancom-paretheirexpectedreturnsfrombuyingeitheralong-termsecurityorasuccessionofshort-termsecurities.Theywillbuythelonger-termsecurityiftheirexpectationsaboutthecourseofinterestratesoverthesecurity’slifetimesupporttheirviewthatthelonger-terminstrumentismoreattractive.Investorswillcontinuetoswitchtolonger-termissuesuntilthoseratesfall,relativetoshorterrates,byenoughtoremovetheexpectedinterestrateadvantageofthelonger-termissues.Investorsformtheirexpectationsonthebasisoftheoutlookforinflationandforrealinterestrates,whichwill,inturn,beinfluencedbyexpectationsabouteconomicactivity,monetarypolicyandfiscalpolicy.Whenbusinesscyclesfollowwhatisconsideredthetradi-tionalpattern,theshapeoftheyieldcurvemaydothesame,becausethetraditionalbusinesscycleisaccompaniedbycyclesininflationandcreditdemands.A‘normal’upward-slopingyieldcurvewouldemergewhenamajoraccelerationordecel-erationininflationwasnotexpected(Figure10.1,yieldcurve HowcanyoupredictthedirectionofUSinterestrates?227EDCABInterestrateTimetomaturityFigure10.1Yieldcurvesovera‘normal’businesscycle.(Source:USMonetaryPolicyandFinancialMarkets(1998)Ann-MarieMeulendyke.FederalReserveBankofNewYork.)A).Towardsthelatterpartofarecession,theyieldcurvewouldbeexpectedtoslopeupwardsmoresharplythan‘normal’(yieldcurveB).Short-termrateswouldfallmorethanlong-termrates,sincetherecessionwouldnotbeexpectedtopersistthroughoutthelifeofthelong-termdebtinstruments.Asarecoverygotunderway,theyieldcurvewouldinitiallyremainsteep.Atsomestageitwouldbelikelytoflattensomewhatasshort-terminterestratesrose,butitwouldgenerallyremainupward-sloping(yieldcurveC).Ifsignificantinflationarypressuresbecomeevident,however,theFedfundsrateandothershort-termrateswouldbelikelytorisesub-stantially,promptedbytightermonetarypolicyandchangesinthemarket’sexpectationsaboutinflation.Theyieldcurvewouldthentendtoshiftupwardandflatten(yieldcurveD).Aninvertedordownward-slopingyieldcurve(yieldcurveE)wouldreflectmarketviewsthatshort-terminterestrateswerealreadyhighenoughtoreducerealGNPgrowthandinflationandthataslowingineconomicactivityandinflationshouldleadtoadeclineininterestrates.Whatistheempiricalevidencetosupporttheuseofyieldcurvesasbusinesscycleturningpoints?ArthurEstrellaandFrederickMishkin,intheirmodeldis-cussedbelow,estimatetheprobabilityofarecessionasbeingdependentontheyieldcurvespread,definedasthedifferencebetweeninterestratesonthe10-yearUSTreasurynoteand 228EconomicsforFinancialMarketsthethree-monthUSTreasuryBillfortheperiod1960–1995.Themodelestimatestheprobabilityofrecessionfourquartersinthefutureasafunctionofthecurrentvalueoftheyieldcurvespread.AsTable10.4showstheestimatedprobabilityofarecessionfourquartersaheadestimatedfromthemodelis10percentwhenthespreadaverages0.76percentagepointsoverthequarter,50percentwhenthespreadaverages–0.82percentagepoints,and90percentwhenthespreadaverages–2.40percentagepoints.Consequentlythemorenegativetheyieldspreadthehigherthelikelihoodofrecession.Theusefulnessofthemodelcanbeillustratedthroughthefollowingexamples.Considerthatinthethirdquarterof1994,thespreadaveraged2.74percentagepoints.Thecorrespond-ingpredictedprobabilityofrecessioninthethirdquarterof1995wasonly0.2percent,andindeed,arecessiondidnotmaterialize.Incontrast,theyieldcurvespreadaveraged–2.18percentagepointsinthefirstquarterof1981,implyingaprobabilityofrecessionof86.5percentfourquarterslater.Aspredicted,thefirstquarterof1982wasinfactdesignatedarecessionquarterbytheNationalBureauofEconomicResearch.Table10.4EstimatedRecessionProbabilitiesforaProbitModelUsingtheYieldCurveSpreadFourquartersaheadRecessionprobabilityValueofspread(percent)(percentagepoints)5+1.2110+0.7615+0.4620+0.2225+0.0230–0.1740–0.5050–0.8260–1.1370–1.4680–1.8590–2.40Source:Estrella,A.andMishkinF.CurrentissuesinEconomicsandFinance.FederalReserveBankofNewYork,1996. HowcanyoupredictthedirectionofUSinterestrates?229Sowhatistheadvantageofusingyieldcurves?First,forecastingwiththeyieldcurvehasthedistinctadvan-tageofbeingquickandsimple.Withaglanceatthe10-yearnoteandthree-monthbillratesonthecomputerscreen,anyonecancomputeaprobabilityforecastofrecessionalmostinstan-taneouslybyusingTable10.4.Second,asimplefinancialindicatorsuchastheyieldcurvecanbeusedtodouble-checkbotheconometricandjudgmentalpredictionsbyflaggingaproblemthatmightotherwisehavegoneunidentified.Forexample,ifforecastsfromanecono-metricmodelandtheyieldcurveagree,confidenceinthemodel’sresultscanbeenhanced.Incontrast,iftheyieldcurveindicatorgivesadifferentsignal,itmaybeworthwhiletoreviewtheassumptionsandrelationshipsthatledtotheprediction.Thirdtheexpectationtheoryofthetermstructure,discussedinChapter3,providesatheoreticalfoundationforthepredictivepoweroftheyieldcurve.Rule3:watchwhattheFedwatches–notwhatyouthinkitshouldwatchIntrackingandanticipatingtheFederalReserve’stradingdeskactions,financialmarketeconomistsbeginwithaclosereadingofthemostrecentlyreleasedFOMCminutes.TheFedwatcherwilltrytounderstandtheCommittee’sconcernsandthebalanceofopinionamongitsmembers.TheywillidentifythosefactorsthattheFOMCchosetoemphasizeinitsguidelinestotheFedopenmarketdeskinordertopredictachangeinreservepressuresthatmightbemadebetweenmeetings.Beforethepolicyrecordisreleased,theeconomistsmustinterpretdevelop-mentsinthelightoftheirunderstandingofthecommittee’sprimaryemphasis,beitthedifferentmeasuresofinflationsuchasnon-farmpayrollemploymentortheconsumerpriceindex,differentmonetaryaggregatesorthebehaviourofnominalgrossdomesticproduct.ThentheymustgaugethelikelybehaviourofthosevariablesthattheFederalReserveappearstobefollowingmostclosely.Intrackingdeskoperationsandevaluatingwhetherreservepressureshavebeenmodified,analyststrytodistinguish 230EconomicsforFinancialMarketsbetweenthedefensiveanddynamicaspectsofopenmarketoperations.Anopenmarketoperationmayrepresentachangeinstancetowardthepolicyobjectiveoritmaymerelybedesignedtooffsetthemovementinsomeotherbalancesheetitemortoaddressnormalseasonalmovementinrequiredreserves.Tointerpretopen-marketactionsproperly,Fedwatchersmustanalyseavarietyofstatistics.TheyessentiallyduplicatetheFederalReserve’sdailyestimationofreservesuppliesanddemands.TheoutsideforecastersoperateunderahandicapduringtheperiodsincetheydonothavethedailyflowofreserveinformationavailabletotheirFederalReservecounterparts.EachThursdayafternoon,aftertheFederalReserve’s4:15releaseofavarietyofstatistics(includingweeklydataontheFederalReservebalancesheet,knowninthemarketsasTablesH.3andH.4.1),theFedwatchersanalysetheborrowingatthediscountwindow,excessreserves,andotherfactorstotrytoassesstheFederalReserve’spolicystance.Undermostcircum-stances,theanalystswillexpectborrowingandreservepres-surestocontinuenearthelevelrecentlyprevailing.TheywillalsoestimatewhatrangefortheFedfundsrateappearstobeconsistentwithsuchborrowing.Figure10.2providesasummaryofhowchangesinfreereservesaffecttheFedfundsrate.FederalReservemoneysupplytargetsarereallynon-borrowedreservestargets.Openmarketoperationsaredesignedtochangefreereserves.Acontractionarymonetarypolicyinvolvesthesaleofsecurities,forcingFedfundsup,andanexpansionarymonetarypolicyinvolvingthepurchaseofsecuritiesbringsdownrates.TheFederalReservefocusesontheratioofnon-borrowedreservestorequiredreservesandtodiscountwindowborrowingasmeasuresofthestrengthofmonetarypolicy.IftheratioofExcessReserves(ER)–DiscountWindowBorrowing(DWB)=FreeReservesDWB>ER=NetBorrowedReserves(NEBR)ER>DWB=NetFreeReserves(NFR)TightMonetaryPolicy:EasyMonetaryPolicy:–FreeReservesFall–FreeReservesRise–NetBorrowedReservesRise–NetBorrowedReservesFallFedFundsRateRisesFedFundsRateFallsFigure10.2Howdoyoumeasurethestrengthofmonetarypolicy. HowcanyoupredictthedirectionofUSinterestrates?231non-borrowedreservestorequiredreservesfallsandthereisincreaseddiscountwindowborrowingtherearepressuresforfreereservestofallandFedfundstorise.Iftheratioofnon-borrowedreservestorequiredreservesrisesandthereisafallindiscountwindowborrowing,therearepressuresforfreereservestoriseandFedfundstofall.Rule4:keepaneyeonthethree-monthEuro–DollarfuturescontractThiscontractisamongstthosefinancialinstrumentsmostsensitivetoFedfundsratechangesandindicateswhatinvestorsthinkthree-monthdepositswillcostwhenthemarketexpires.Itisexpressedas:100minustheannualizedinterestrate.Soifthethree-monthseuro–dollarfuturescontractispricedat95.00thisindicatesanexpectedthree-monthinterestrateofaround5percent.Clearlyifthecontractpricerisesabove95.00interestratesareexpectedtofallandifthecontractpricefallsbelow95.00theninterestratesareexpectedtorise.Thereasoningbehindwhythree-montheuro–dollarfuturescontractsaresomarketsensitiveisbasedontherelationshipbehindthedeterminantsoffuturesprices.Thepricesofshort-terminterestratefuturesareinfluenced,forthenearermaturitiesatleast,byarbitragebasedonforward/forwardcalculations.Supposethatthethree-monthinterestrateis14percentp.a.whilstthesix-monthrateis15percentp.a.Atradercouldborrowforthreemonthsandlendforsixmonthsandtherebyguaranteeaprofitfromthe1percentmarginduringthefirstthreemonths.However,atraderisatriskfromariseinthethree-monthinterestratebythecommencementofthesecondthree-monthperiod.Thereisathree-monthrateforthesecondperiodabovewhichthelossonthesecondperiodwillpushthewholeoperationintoaloss.Thatistheforward/forwardrate.Supposethatthetraderlends$1millionforsixmonthsat15percentp.a.andborrowsitforthreemonthsat14percentp.a.Hewillreceive$1,072,380.50attheendofthesix-monthperiod.Meanwhilehemustpay$1,033,299.50attheendofthefirstthreemonthsandmustborrow$1,033,299.50inordertorepaythedebt.A$39,081interestpaymentonthissecondloanwould 232EconomicsforFinancialMarketsmeanthatthetraderbreaksevenontheexercise,sincetheseconddebtcouldberepaidwiththe$1,072,380.50fromthe$1millionoriginallylent.Onathree-monthloanof$1,033,299.50,$39,081correspondstoarateofinterestof16.01percentp.a.Thisistheforward/forwardrateandarbitragetendstoensurethatthefuturesrateapproximatescloselytoit.Ifthefuturesrateweresignificantlybelowtheforward/forwardrate,arbitrageurswouldlendlongandborrowshort,usingthefuturesmarkettoguaranteefutureshort-terminterestrates.Thiswouldinvolvesellingfutures(commitmentstofutureborrowing)andtheincreasedsaleswouldpushdowntheirprices.Thefallinfuturespricescorrespondstoariseinfuturesinterestrates.Thisincreaseinfuturesinterestrateswilltendtoeliminatethescopeforfurtherarbitrageprofits.Rule5:useTaylor’sruleasaguidetochangesinFederalReservepolicyIfyouwantedtosetinterestratestoachievestablepriceswhileavoidinglargefluctuationsinoutputandemployment,howwouldyoudoit?ThisisexactlythequestionthatAlanGreenspanandothergovernorsoftheFederalReservemustaskthemselveseveryday.AswediscussedinChapter1theshort-termpolicyinstrumentthattheFederalReservenowsetsistheFedfundsrate–theshort-terminterestrateatwhichbanksmakeloanstooneanother.WhenevertheFederalOpenMarketCommitteemeets,itchoosesatargetfortheFedfundsrate.TheFederalReserve’sbondtradersarethentoldtoconductopen-marketoperationsinordertohitthedesiredtarget.ThehardpartoftheFederalReserve’sjobischoosingthetargetfortheFedfundsrate.Twoguidelinesareclear.First,wheninflationheatsup,theFedfundsrateshouldrise.Anincreaseintheinterestratewillmeanasmallermoneysupplyand,eventually,lowerinvestment,loweroutput,higherunem-ployment,andreducedinflation.Second,whenrealeconomicactivityslows,asreflectedinrealGDPorunemployment,theFedfundsratewouldbeexpectedtofall.Adecreaseintheinterestratewillmeanalargermoneysupplyand,eventually,higherinvestment,higheroutput,andlowerunemployment. HowcanyoupredictthedirectionofUSinterestrates?233TheFederalReserveneedstogobeyondthesegeneralguidelines,however,anddecidehowmuchtorespondtochangesininflationandrealeconomicactivity.ToassessFederalReservepotentialbehaviourmanyFedwatchersareapplyingaruleknownastheTaylorrule,namedafterJohnTaylor,aneconomistformerlyatStanfordUniversity.MrTaylor’sargument(1994)isthatcentralbanksoughtto‘leanagainstthewind’whensettinginterestrates.Hesuggested,therefore,thatshort-termnominalinterestratesshouldbeequaltothesumoffourelements.Thefirstistherealshort-termratethatisconsistentwith‘neutral’monetarypolicy,i.e.,onethatisneitherexpansionarynorcontractionary.Thesecondistheexpectedinflationrate.Third,inthesimplestandcommonestversionoftheTaylorrule,0.5percentagepointsshouldbeaddedto,orsubtractedfrom,short-termratesforeverypercentagepointbywhichthecurrentinflationrateisaboveorbelowitstarget.Andfourth,thesameadjustmentshouldbemadeforthe‘outputgap’,i.e.,foreverypercentagepointbywhichGDPisaboveorbelowitslong-termtrendlevel.Theideaisthatoutputabovetrendisasignalofinflationontheway;outputbelowtrendisasignalofthereverse.Severalstudieshavefoundthatcentralbankshave,ineffect,beenfollowingtheTaylorruleforsometime.Aswithanysimpleruleitissubjecttoobviouslimitations.First,itisheavilydependentontheestimationoftrendGDP,wherethereisplentyofscopefordisagreement.Second,the10109988ActualFederalfundsrate77Percent66Percent554Taylorrule433221988199019921994199619982000Taylorrule:FF-Infl.=2%+.5*GDPgap+.5*(Infl.-2%)Figure10.3WhattheTaylorruletellsusaboutthestanceofmonetarypolicy.(Source:FederalReserveBankofNewYorkandauthorsowncalculations.) 234EconomicsforFinancialMarketsappropriatelevelofinterestratessuggestedbytheruledependsonthechosenmeasureofinflation,e.g.PCEpriceindex,GDPdeflator,CPI,coreCPI,wageinflation–thelistislong.DespitetheselimitationstheTaylorrule,ascanbeseenfromFigure10.3,doesprovideausefulpredictorofthestanceofmonetarypolicywhichFedwatcherswouldbeadvisedtokeepacloseeyeon.Noticehowcloselytogetherthetwoseriesmove.JohnTaylor’smonetaryrulemaybemorethananacademicsuggestion.Rule6:payattentiontowhattheFederalReservedoes–nottowhatitsaysThismaysoundratherobviousbutitisnotnecessarilythecasethattheFederalReservedoeswhatitsaysitwill.FormerFederalReserveChairmanArthurBurns(1970–1978)andG.WilliamMiller(1978–1979)bothtalkedoftheneedforrestric-tiveactionbutdidverylittle.Itmustbesaid,however,thatthesamechargecannotbemadeagainsteitherPaulVolcker(1979–1987)orAlanGreenspan(1987–).Rule7:viewpotentialFederalReservepolicyshiftsasareactionto,ratherthanacauseof,undesiredeconomic/monetaryconditionsAlanGreenspanhasfrequentlyreferredtotheeconomybeingthepatientwhilsttheFederalReserveisthedoctor.Ifthepatientishyperactivethedoctorshouldtaketheappropriate HowcanyoupredictthedirectionofUSinterestrates?235action.AsformerFederalReserveChairmanWilliamMcChes-neyMartin(1951–1970)famouslycommented‘theroleoftheFedchairmanistotakeawaythepunchbowljustasthepartyisstarting’.Rule8:rememberthatultimatelytheFederalReserveisacreatureofCongressAlthoughinsulatedintheshort-termfrompartisanpoliticalpressuresitisnotinsulatedinthelongerterm.Thelimitsofitsindependenceareclearlydelineated.TheFederalReservewascreatedbyanactofCongressand,likeanyagencysocreated,canbechangedorterminatedaltogetherbyCon-gress.WhatCongresscreatesitcanalsodestroy!SoalthoughtheFederalReservereceivesitsmandatefromCongressregardingwhatitshouldtrytoachievewithmonetarypolicyovertime,thesedecisionsaresubjecttoCongressionalReview.FormerChairmanMartinlikedtodescribetheFed-eralReserveas‘independentwithinthegovernment,notofthegovernment’.FederalReservegovernorsareappointedto14-yearterms.However,mostFederalReservegovernorsdonotserveafull14-yearterm.Manyareappointedinthemiddleofatermtoreplaceadepartinggovernor.Amongthegovernorswhohaveservedsince1946,termsvariedfromthethreemonthsservedbyPaulEMiller,whodiedinoffice,tothe28yearsservedbyM.S.Szymczak,whowasappointedin1933andremainedagovernoruntil1961,havingbeenreappointedtwice.Thereissomeevidencetosuggestthattheaveragelengthofagover-nor’stermhasdecreasedsinceWorldWarII.Governorsappointedbefore1960stayedanaverageof11years,whilethoseappointedinorafter1960averagedonlysevenyears.AnewUSpresidentislikelytobeabletochooseseveralgovernorsfortheFederalReserveduringhisorhertermofoffice.Throughthechoiceofnominees,thepresidentcaninfluencethedirectionofmonetarypolicy.PresidentGeorgeW.Bushisintheunusualopportunityofinfluencingtheselectionofalargenumberofgovernors. 236EconomicsforFinancialMarketsRule9:followthetrendsinFOMCdirectives:howtointerpretFedspeak?TheFOMCdirectivepriortoAugust1997AteachmeetingtheFOMCissuedapolicydirective,thelanguageofwhichdeterminedwhetherthedirectivewassymmetricorasymmetric.WhiletheFOMCneverformallystatedthepurposeofanasymmetricpolicydirectiveitwasofteninterpretedasindicatingthelikelydirectionoftheFOMC’snextpolicyaction.OneofthemostimportantdecisionsreachedatFederalOpenMarketCommitteemeetingsiswhethertoeaseortightenmonetarypolicy.TheFOMCtransmitsitsdecisiontotheFederalReserveBankofNewYork(whereopenmarketoperationsareactuallyexecuted)inadomesticpolicydirectivethatguidesmonetarypolicyinthesubsequentweeks.OneofthekeyrolesofaFedwatcheristodecodetheFOMCpolicydirective.Thisdidnotusetobeasstraightforwardasitcurrentlyis.ThedomesticpolicydirectivesissuedbytheFOMCinrecentyearshavecontainedtwoparts.Thefirstpartsummarizesavailableinformationabouttheeconomythatprovidesacontextfortheactionstaken.Thesecondpartisadiscussionofpolicyandtheactualdirective.UpuntilJuly1997thedirectiveusedthefollowingkeywording.‘Intheimplementationofpolicyfortheimmediatefuture,theCommitteeseeksto:(1)theexistingdegreeofpressureonreservepositions.InthecontextoftheCommittee’slong-runobjectivesforpricestabilityandsustainableeconomicgrowth,andgivecarefulconsiderationtoeconomic,financialandmonetarydevelopments.(2)somewhatgreaterreserverestraintor(3)slightlylesserreserverestraintbeacceptableintheintermeetingperiod.’Theimplicationofthewordingintheblankspacesisdiscussedbelow.PolicydirectivesexpressthepreferenceoftheFOMCfortheimplementationofmonetarypolicyduringtheperioduntilthenextFOMCmeeting.Symmetricaldirectivesexpressnobias HowcanyoupredictthedirectionofUSinterestrates?237towardeithergreaterease(alowerFedfundsrate)ortowardgreaterrestraint(ahigherFedfundsrate).Asymmetricaldirectivesdoexpressapolicybias.Bywritinganasymmetri-caldirective,theFOMCempowersthechairmantoraiseorlowertheFedfundsratetargetduringtheintermeetingperiod.Whenthewordingabouttighteningoreasingreservecondi-tionswasidentical,thenthedirectivewassymmetric.Acombinationofwordingthatused‘slightly’or‘somewhat’with‘would’or‘might’indicatedanasymmetricdirective.Forexample,ifthedirectivestatedthat‘somewhatgreaterreserverestraintwouldorslightlylesserreserverestraintmightbeacceptable’thechairmanhadtheauthority,butnottheobligationtodirecttheFedopenmarketdesktoincreasepressureonreservesinthebankingsystem,therebysettingahigherFedfundsratetarget.Inpractice,thechairmanexer-cisedthisauthorityveryinfrequently,andtypicallyinvolvedtheothermembersoftheFOMCintheprocess.Theterms‘somewhat’and‘slightly’,‘would’and‘might’,helpedtoexpressthestrengthoftheCommittee’sbias.Lookingattheblankspacesabove,asymmetricdirectivewouldindicateforspace(1):‘Decrease’–meaninganeasingofmonetarypolicyor‘Increase’–meaningatighteningofmonetarypolicyor‘Maintain’–meaningnoimmediatechangeinmonetarypolicy.Thisthenindicatedwhetherinterestrateswererising,fallingorstayingthesameinthenearfuture.Soitwasthesecondtwoblankspacesthatdeterminedtheso-calledbiasofthedirectiveandwereparticularlyimportantwhenthefirstblankspaceindicatedthatthemainthrustis‘maintained’.Thechoicesforboththesecond(2)andthethird(3)blanksarethewords‘would’and‘might’.Thekeyinsightisthat‘would’isstrongerthan‘might’.Ifthemainthrustofthedirectiveis‘maintain’andthedirectivesaysthatslightlygreaterreserverestraintmightorslightlylesserreserverestraintwouldbeacceptable,thedirectivewasreferredtoasbiasedorasymmetrictowardsease.Pairingmightwithmightorwouldwithwouldgaveasymmetricdirective.Pairingwouldandmightwasknownasbiasedorasymmetrictowardrestraint.AdirectivethatwasbiasedtowardseasewasintendedtogivetheChairmansomewhatmoreleewayinthe 238EconomicsforFinancialMarketsdirectionofeaseintheday-to-dayimplementationofpolicybetweenmeetings.TheFOMCdirectiveschangeofwordingWitheffectfromtheFOMCAugust1997minutes,thewordinghasbeenalteredasfollows.‘Intheimplementationofpolicyfortheimmediatefuture,thecommitteeseeksconditionsinreservemarketsconsistentwithmaintainingtheFederalfundsrateatanaverageofaround51percent.Inthecontext2oftheCommittee’slong-runobjectivesforpricestabilityandsustain-ableeconomicgrowth,andgivingcarefulconsiderationtoeconomic,financialandmonetarydevelopments,asomewhathigherFederalfundsratewouldoraslightlylowerfederalfundsratemightbeacceptableintheintermeetingperiod.Thecontemplatedreservecondi-tionsareexpectedtobeconsistentwithmoderategrowthinM2andM3overcomingmonths.’Anexplicittarget,5.5percenthere,isnowformallystated.Thewordingnow,‘asomewhathigherFedfundsratewouldoraslightlylowerFedfundsratemightbeacceptableintheintermeetingperiod’,asbefore,indicatesapreferencefortighteninginterestrates.Rule10:fearsofinflationprovokefasterchangesinmonetarypolicythandofearsofunemploymentThereasoningbehindthisrulecomesfromAlanBlinder,formerViceChairmanoftheBoardofGovernorsoftheFederalReserve,inhispublicationCentralBankinginTheoryandPractice(1998).Hediscussestheextenttowhichmonetarypolicyshouldtaketheformofa‘pre-emptivestrike’whenfacedwithfightingeitherinflationorunemployment.Blinderarguesthatthelagsinmonetarypolicycouldbelongerforinflation-fightingthanforunemployment-fighting,callingforearlierpre-emptionintheformercase.Hethencitesempiricalevidencethatsupportshisviews. HowcanyoupredictthedirectionofUSinterestrates?239Blinderthengoesontohighlightthatgiventhenatureofcommitteedecision-making,systematicpolicyerrorscancon-tinuewhichtheninducethecentralbanktomaintainitspolicystancetoolong.InBlinderswords‘monetarypolicydecisionstendtoregresstowardsthemeanandtobeinertial.’GiventhatBlindercombinespracticalFederalReserveexperiencewithbeingadistinguishedacademic,Fedwatcherswouldbeadvisedtoheedhisviews. 11Derivatives:whatdoyouneedtoknowabouteconomicstounderstandtheirroleinfinancialmarkets?†Whatarederivatives?Derivativesarecontractswhichgiveonepartyaclaimonanunderlyingasset(derivedfromthecashvalueofanunderlyingasset)atsomepointinthefuture,andbindacounterpartytomeetacorrespondingliability.Thecontractmightdescribeanamountofcurrency,asecurity,aphysicalcommodity,astreamofpayments,oramarketindex.Itmightbindbothpartiesequally,orofferonepartyanoptiontoexerciseitornot.Itmightprovideforassetsorobligationstobeswapped.Itmightbeabespokederivativecombiningseveralelements.Whetherderiv-ativesareorarenottradedonexchanges,theirmarketpricewilldependinpartonthemovementofthepriceoftheunderlyingassetsincethecontractwascreated.Therapidgrowthofderivativestradingaroundtheworldinrecentyearshasbeenpropelledbytheinternationalizationofcapitalmarketsingeneral,bytechnologicaladvancesincomputersandtelecommunications,andbytheincreasinglyfiercecompetitionamongbigbanksandsecuritieshousestodeviseandsellproducts.†ThecontentsofthischapterarediscussedinmoredetailinKettell,B.(2001)FinancialEconomics.FinancialTimes–PrenticeHall. Derivatives:whatdoyouneedtoknowaboutthem?241Wheredidderivativescomefrom?Tradinginderivativecontractshasalonghistory.ThefirstrecordedaccountsofderivativecontractscanbetracedbacktothephilosopherThalesofMiletusinancientGreece,who,duringwinter,negotiatedwhatwereessentiallycalloptionsonoilpressesforthespringoliveharvest.DelaVegareportedin1688thatoptionsandfutures,or‘timebargains’astheywerethenknown,weretradingontheAmsterdamBoursesoonafteritwasopened.EvidencealsosuggeststhatfuturescontractsforriceweretradedinJapaninthe17thand18thcenturies.ThefirstformalizedfuturesexchangeintheUnitedStateswastheChicagoBoardofTrade,whichopenedin1848with82members.InMarch1851,thefirstfuturescontractwasrecorded.Thecontractcalledforthedeliveryof3000bushelsofcorninJuneatapriceofonecentperbushelbelowtheMarchprice.ListedstockoptionsbegantradinginApril1973ontheChicagoBoardOptionsExchange(CBOE).Otherexchangesbeganofferingstockcalloptionsin1975andputoptionsin1977.Therecentrevolutioninoptionpricingtheoryalsodatesto1973withthepublicationbyFischerBlackandMyronScholesoftheirclassicpaperonoptionvaluation.Sincethepublicationofthatpaperthevaluationofoptionsandvariousotherderivativecontractshasbeenoneoftheprimaryareasofresearchamongfinancialeconomists.SometerminologyDerivativesareoftendescribedasbeingcomplexinstrumentsthatdefyunderstandingforthemathematicallyunsophisti-cated.Despitetheirintimidatingappearancetheyareinfactconstructedfromsimpleelements,knowntothefinancialmarketsforliterallycenturies.Takethemostbasicofderivativetransactions,aforwardcontract.Onepartyagreestobuy,say,$1minthreemonths’time,atapricefixedtodayinsterlingterms.Themathematicsofthetransactionarewellwithinthecapacityofapocketcalculator.Ifprevailinginterestratesarehigherforthedollar 242EconomicsforFinancialMarketsthanforsterling,somebodywhowantstobuydollarsforwardforpaymentinsterlingwillbequotedapricelowerthantheonethatisprevailingfortransactionsthataresettledimmediately.Futurescontractsdifferfromforwardcontractsbyvirtueofbeingtradedonofficialexchanges.Tomaketradingeasier,theirtermswillbestandardonessetbytheappropriateexchange;theywillbeforafixedquantity(ofbonds,orporkbelliesorwhateverinstrumentisbeingtraded)andwillrunforafixedperiod.Optionsareaformofforwardcontractsinwhichthebuyercandecidewhetherornottoexercisearighttobuy(orsell)theunderlyingassetwithinanagreedtime.Theselleroftheoptionthenhastoworkouthowtopricetheprobabilitythattheoptionwillorwillnotbeexercised.Onlyin1973didtwoAmericanfinancialeconomists,MyronScholesandFischerBlack,pro-videaplausibleanswertotheoptionpricingproblembydevisingamathematicalmodelwithseveralinputs,themostimportantofwhichwasthevolatilityofthepriceoftheunderlyingasset.Swapscompletethesimpletaxonomy.Albeitonaratherlargerscale,aninterest-rateswapworksjustasif,forsoundfinancialreasons,personAwithafixed-ratemortgage,andpersonBwithafloating-ratemortgageofthesamesize,agreetoassumeresponsibilityforoneanother’sinterestpayments.PersonAwilltakeoverthefloating-ratepaymentsandpersonBwilltakeoverthefixed-ratepayments.Inreallife,bigborrowersmayswapinterest-rateorcurrencyobligationsbecausetheydisagreeoverinterest-ratetrends,orbecausetheyfinditcheapertoborrowmoneyinforeignmarkets.AJapanesecompanywantinglong-termJapaneseyenmayfinditcheapertoborrowUSdollars,thenswapthemintoyen.Table11.1providesaformaldefinitionoftheprincipalderivativescontractstraded,forwards,futures,optionsandswaps.Whatisanoption?Optionsareoneofthemostpowerfulderivativecontracts.Anoptionisacontractbetweentwopartiesthatgivesthebuyertherightbutnottheobligationtobuyorsellaspecificquantityofacommodityorinstrumentatanagreedpriceforaspecified Derivatives:whatdoyouneedtoknowaboutthem?243Table11.1DerivativesDefinedForwardAcontracttobuyorsellaspecifiedamountofadesignatedContract:commodity,currency,security,orfinancialinstrumentataknowndateinthefutureandatapricesetatthetimethecontractismade.Forwardcontractsarenegotiatedbetweenthecontractingpartiesandarenottradedonorganizedexchanges.FuturesAcontracttobuyorsellaspecifiedamountofadesignatedContract:commodity,currency,security,orfinancialinstrumentataknowndateinthefutureandatapricesetatthetimethecontractismade.Futurescontractsaretradedonorganizedexchangesandarethusstandardized.Thecontractsaremarkedtomarketdaily,withprofitsandlossessettledincashattheendofthetradingday.OptionAcontractthatgivesitsownertheright,butnottheobligation,toContract:buyorsellaspecifiedassetatastipulatedprice,calledthestrikeorexerciseprice.Contractsthatgiveownerstherighttobuyarereferredtoascalloptionsandcontractsthatgivetheownertherighttosellarecalledputoptions.Optionsincludebothstandardizedproductsthattradeonorganizedexchangesandcustomizedcontractsbetweenprivateparties.SwapAprivatecontractbetweentwopartiestoexchangecashflowsinContract:thefutureaccordingtosomeprearrangedformula.Themostcommontypeofswapisthe‘plainvanilla’interestrateswap,inwhichthefirstpartyagreestopaythesecondpartycashflowsequaltointerestatapredeterminedfixedrateonanotionalprincipal.Thesecondpartyagreestopaythefirstpartycashflowsequaltointerestatafloatingrateonthesamenotionalprincipal.Bothpaymentstreamsaredenominatedinthesamecurrency.Anothercommontypeofswapisthecurrencyswap.Thiscontractcallsforthecounterpartiestoexchangespecificamountsoftwodifferentcurrenciesattheoutset,whicharerepaidovertimeaccordingtoaprearrangedformulathatreflectsamortizationandinterestpayments.period.Theoptionbuyerpaysthesellerapremiumfortheprivilegeofbeingabletobuyorselltheinstrument,atafixedprice,withouthavingthecommitmenttodoso.Totakeanexample,consideranoptiontobuygoldatUS$400perounce.LetussaythemarketpriceofgoldiscurrentlyUS$395.TheoptionbuyerpaystheoptionsellerapremiumofUS$3.50.Theoptionbuyerhastheright,butnottheobligationtobuygoldatUS$400.ItwillbeprofitablefortheoptionbuyertoexercisethisrightifthepriceofgoldrisesaboveUS$403.50.However,ifthepriceofgoldfallsinthemarketthentheoption 244EconomicsforFinancialMarketsbuyerhasnocommitmenttobuygoldatUS$400,andtheoptionbuyercanthenallowtheoptiontoexpireunexercised,andpurchasegoldatthecheapermarketprice.Itisimportanttobecomefamiliarwiththeterminologyoftheoptionmarket.Asummaryoftheprincipaltermsisillustratedbelow.TheoptionbuyerbecomestheHolder.TheoptionselleriscalledtheWriter.ACalloptiongivestheownertherighttobuyaspecifiedquantityofacommodityatanagreedpriceoveragivenperiod.APutoptiongivestheownertherighttosellaspecifiedquantityofacommodityatanagreedpriceoveragivenperiod.ThePremiumisthepricepaidfortheoption.TheStrikePriceorExercisePriceistherateatwhichtheoptionmaybeexercised;inotherwords,itisthepricethathasbeenagreedundertheoptioncontract.TheExpiryDateisthefinaldateonwhichtheoptioncanbeexercised.AEuropean-styleoptioncanbeexercisedonlyontheexpirydate,whereasanAmerican-styleoptioncanbeexercisedatanydatepriortoandincludingtheexpirydate.(Notethesetermshavenogeographicalsignificance.)Exchange-tradedversusover-the-counter(OTC)optionsOptionsmaybetradedonexchanges,i.e.,inaphysicallocation,orontheover-the-counter(OTC)market,inwhichdealingtakesplacebetweentwocounterparties,usuallyoverthetelephone.Exchange-tradedoptionshavethefollowingcharacteristics.Fixedexpirydates,generallyatthree-monthlyintervalsforthethirdWednesdayinMarch,June,SeptemberandDecember.Maturitiesgenerallyuptotwoyears.Strike/exercisepricesatfixedintervals.Fixedcontractsizes.Standardizationofcontracts.Thismeansthatmarketstendtobeliquid.Inotherwords,bid-offerspreads(thedifference Derivatives:whatdoyouneedtoknowaboutthem?245betweenthebuyingandsellingprice)tendtobenarrow,andlargeorderscanusuallybetransactedfairlyeasily.Giventhattheseoptionsaretradedonregulatedexchanges,tradingiscloselymonitored.Theclearing-houseoftheexchangeactsasthecounterpartytoeverytrade,thusthecreditrisk,i.e.,theriskofdefaultonatrade,isstandardizedandlimited.Pricesarepubliclyquoted,i.e.,tradingtakesplacebyopenoutcrybetweentradersontheflooroftheexchange.Pricesarereportedbyinformationvendors,suchasBloombergandReuters,andpricesandvolumesarereportedinthefinancialpress.Over-the-counteroptionshavethefollowingcharacteristics.Strikerates,contractsizesandmaturityareallsubjecttonegotiation.Theycanbelongertermthanexchange-tradedoptions;somebankswillwritethemforupto10years.Theholderhasadirectcreditriskonthewriter.Thewriterhasnocreditriskontheholderprovidedthepremiumispaidupfront.Thepriceatwhichtheoptionisdealtisknownonlytothecounterparties.Wheredooptionpricescomefrom?Inordertounderstandoptionpricesitisessentialtounder-standtwokeyconcepts:arbitrageandforwards/futuresmar-kets.Arbitrageisdiscussedbelow.Forwardsandfuturesarefinancialinstrumentsthatrelatepresentandfutureprices,andtheyarecriticalinunderstandingoptionpricing.ArbitrageArbitrageisapowerfulmarketforcethathelpstoestablishthevalueofmanyfinancialinstruments.Whendiscussingarbit-rageitisimportanttodistinguishbetweendeterministicarbitrageandstatisticalarbitrage. 246EconomicsforFinancialMarketsWhatisdeterministicarbitrage?DeterministicArbitrageistheclassictechniqueofsimultane-ouslybuyingandsellingthesameorequivalentproductsatdifferentpricestoachievearisklessprofit.Forexample,whatdowedoifgoldtradesat$400inNewYorkand$410inLondon?Theanswerisquitesimple:webuylowandsellhigh.Specifically,webuylowfor$400inNewYork,andwesellhighat$410inLondon–andwemake$10risklessly.By‘risklessly’wemeanthereisnoriskofpricesmovingagainstus.Ifwecanexecutethesetwotradessimultaneously,thereisnogoldpricerisk,andwecanbeconfidentofaprofitaslongasotherfactorsdonotintervene.Oneofthebestwaystoillustratearbitrageopportunitiesistouseexamplesbasedonsimpleraffles.Rafflesdefineandclarifysomeoftheideasofprofitandprobabilitythatwillbediscussedfurtherinthischapter.Letusassumethatadailyrafflesellsexactly100ticketseachmorning.Attheendoftheday,oneofthese100ticketsischosen,andtheholderofthatticketwins$1000.Whatisthefairpriceorexpectedvalueofoneticket?Tosolvethisproblem,wedividethe$1000prizeby100ticketsforafairpriceof$10.Ifwepay$10fortheticketandwedonotwin,wewillnotfeelwewerecheatedbecausewepaidtoomuch.Wewillattributeitto,say,theluckofthedraw.Similarly,ifwewin,wewillbeecstatic,butwewillnotthinkweboughtacheapticketbecause,bytheaccidentofprobability,wewontheprize.Whenwedividethevalueoftheprizebythenumberoftickets,weareabletoderivethefairvalueor,instatisticalterminology,theexpectedvalueormeanvalueofeachticket.Whatdowedoifticketssellfor$9insteadof$10?At$9,theticketischeap–socheapthatitisworthbuyingeveryticketintheraffle.Whenthewinningnumberisdrawnattheendofthedaywestandtomakearisklessprofitof$100.Ifweholdallthetickets,wewinthe$1000prize,havingpaidonly$900.Wecanarbitrageadeterministic$100profit–meaningwearecertaintomakethat$100–aslongasthepersonwhocreatedtheraffledoesnotdisappearaftercollectingourmoney.Whatdowedoifticketssellfor$11?Because$11istoomuchtopayforaticket,wewanttosellraffleticketsinsteadofbuyingthemifwecan.Wemightholdourownrafflesellingticketsat$10.50.Afterselling100tickets,wewilltakein$1050.Theprizewehavetopaytherafflewinneris$1000,sowehave$50leftinourpockets.Ifanyraffleticketsellsfor Derivatives:whatdoyouneedtoknowaboutthem?247lessthanfairvalueitisworthbuyingit.Ifitisovervalued,itisworthsellingit.Theeffectoftheserafflescenariosissimilartotheeffectofgoldtradingat$400inNewYorkandat$410inLondon.WhentherearemanybuyersofgoldinNewYork,theirdemandforcesthepriceup.WhentherearemanysellersofgoldinLondon,theirsupplyforcesthepricedown.Nobodycansayexactlywherethepricewillendup,butwepresumeitwillfinishupsomewherebetween$400and$410.Eventually,weknowthatthepricewillequilibratetoafairvalue–thesamepricetobuyersandsellersinallmarkets.Thefairvalueofgolddoesnotnecessarilymeanthisisthepricegoldwilltradeat;itmeansitistheefficientmarketvalueortheexpectedvalue.Lockinginasureprofitbytakingadvantageofmis-pricingisknownasdeterministicarbitrage.Whatisstatisticalarbitrage?Letusassumeforpurposesofillustrationthatraffleticketssellforlessthantheirfairvalue.Letuslookatadifferent,butrelated,kindofarbitrage:statisticalarbitrage.Whatdowedoifraffleticketssellfor$9butwearepermittedtobuyonlyoneticketaday?Dowe:(1)neverbuyaticket,(2)buyaticketonceinawhile,or(3)buyaticketeveryday?Inthiscase,theticketshouldbesellingfor$10butonlycosts$9,sowehavea$1‘edge’,orexpectedprofitperticket.Ifwebuyonlyoneticketaday,weareengagedinstatisticalarbitrage.Wedonothaveacertainprofitifwecannotbuyalltheticketsinanunderpricedraffle.Wehavetodecidewhatisthebestthingtodoinanuncertainsituation.Infact,thecorrectchoiceforsomeonewhocanaccepttheriskofastringoflossesbeforehewinstheprizeisnotone,two,oreventhreetickets.Thefullansweris:buyoneticketeverydayuntiltheuniverseends.Whatdoweexpecttohappenafterbuyingaticketeverydayuntiltheendoftime?Weexpectourfortunetogrowwithoutlimit!Thekeywordinthisscenarioisexpect.Wearenotcertaintowinthismoney,butweexpecttowinthismoney.Weexpecttoearnanaverageof$1adayonthisraffle,becauseour‘edge’,theexpectedvalueofourposition,is$1.Weexpecttomakethatedgeonaverageafterrepeatedtrials.Thisiscalledstatisticalarbitragebecauseitisnotcertainordeterminedthatwewillmakethisprofit,butweexpecttomakethisprofitovertime.Whatdoweexpecttohappenafter100dayswhenwehavespent$900onraffletickets?Weexpecttowinonetime.Arewe 248EconomicsforFinancialMarketsassuredofwinningonetime?Absolutelynot–wecouldloseeverytimeorwecouldwintwo,three,oreven99times.Whatdoweexpecttohappenafter1000days?Therewillbe1000winnersafter1000days.With1000winnersandaonein100chanceofwinningeachday,weexpecttowin10times.Wemaynotwin10times,wemaywinonlyeighttimes,orwemaywin12times.Infact,thereisabouta70percentchancethatwewillwinbetweensevenand13times.Ifweplay1000times,wewillbeverysurprisedifwedonotwinatall,becausetheprobabilityofnotwinningatallin1000triesisextremelysmall,iftheraffleisfair.Themoretimesweplay,thecloserweshouldcometothenumberoftimesweexpecttowinandtotheaverageof$1adayweexpecttomake.Ifweplay1000000times,weexpecttomakecloseto$1000000.Ourprofitmightfallafewhundreddollarsshortof$1000000orriseafewhundreddollarsbeyond$1000000,butthatisafairlysmallpercentagevariationcomparedtothepercentagevariationwemightseeafter100days.After1000000raffles,weexpecttowinabout10000times(1/100of1000000).Statisticianstelluswehaveabouta70percentchanceofwinningbetween9900and10100times.Thelargernumberofrafflesbringsusclosertoourexpectedaverageofonewinforevery100times.Thelongertheperiod,thecloserweexpecttocometotheaveragepayoff.Toapplytheseprinciplestothepricingofderivativeswenowneedtoturntoprobabilitydistributions.ProbabilitydistributionsSupposegoldistradingat$400anouncetoday.Whatpricewillgoldbeinoneyear?Ifweaskmanydifferentpeoplethisquestion,wewillprobablygetmanydifferentanswers.Somepeoplewillbeverypessimistic,predictingadramaticdropingoldprices.Otherswillbeveryoptimistic,predictingalargeriseingoldprices.Anumberofpeoplewillfallinbetweenthetwoextremes.Afterweaccumulatealloftheresponses,wewillgetapictureofwherepeoplethinkgoldisgoingtotradeinayear.ThepicturemightlooksomethinglikeFigure11.1.Thenumbersatthetopofeachbarrepresentthepercentageofpeoplewhopredictthatthepriceofgoldwillreachthatpricecategoryinayear.Ourfirstbar,centredat$350anounce, Derivatives:whatdoyouneedtoknowaboutthem?24925%23%20%15%16%13%12%Probability10%11%8%7%7%5%3%0%350375400425450475500525550Goldprice($/ounce)Figure11.1Surveyofexpectationsaboutthefuturegoldprice.indicatesthat3percentofthepeoplesurveyedthinkgoldwillbearound$350;about7percentofthepeoplethinkitwillbearound$375;12percentpredictapricenear$400,andsoforth.Manypeopleareclusteredinthemiddle,around$450.Thispictureiscalledadistribution.Adistributionischarac-terizedbyitsmeanoraverage–itsexpectedvalue.Adistribu-tionwillalwaysbecentredattheexpectedvalue.Whenweaddupandaveragethedifferentresponsesfromthepeoplesurveyed,wefindthat,forthisparticularexample,themeaniscentredaround$450.(Themeancalculatedfromtheactualresponsesis$453.50.)Onaverage,thepeopleinthisgroupfeelthatthefuturepriceofgold,thatisthepriceofgoldayearfromnow,shouldbeapproximately$450.Adistributionisalsocharacterizedbyitswidthordispersion,whichissometimesexpressedasthestandarddeviationorthevolatility.Youcanseeinthisdistributionthat,eventhoughitiscentredaround$450,thereisagreatdealofvariationintheresponses.Somepeopleestimateapriceaslowas$350,andsomepeopleestimateapriceashighas$550.Thestandarddeviationmeasuresthedispersioninthedistribution,andforourgoldpricesurveydistributionthismeasureofdispersionisaround$50.Themeanandthestandarddeviationaretwoimportantquantitativecharacteristicsofthedistribution.Manydistribu-tionsweencounterinnatureandinthefinancialmarketshaveaparticularshapecalledanormalorbell-shapeddistribution. 250EconomicsforFinancialMarketsReturnsforcommodities,suchasgold,orforcurrenciesorstocksorbondshaveunderlyingdistributionsthatareoftenapproximatelynormal.Anormaldistributionischaracterizedinpartbyitssymmetryaboutthemeanandbythefactthatitishighinthemiddleandlowattheends.Wewillassume,forpurposesoftheillustrationthatfollows,thatgoldpricesareapproximatelynormallydistributed.ThenormaldistributionhassomeveryusefulcharacteristicsandtheseareillustratedinFigure11.2.Inanormaldistributionofgoldpriceforecasts,wehave68percentconfidencethatthefuturepricewillbewithinonestandarddeviationofthemean.Inourforecastdistribution,themeanisabout$450,andthestandarddeviationisabout$50.Assumingthisdistributionisnormal,weare68percentconfidentthatthefuturepricewillfallsomewherebetween$400and$500–$450minus$50and$450plus$50.Addingthepercentageresponsesinthepricerangebetween$400and$500onourbarchartinFigure11.1,wefindthatabout75percentofourforecastersfeelthatthefuturepricewillbewithinonestandarddeviationofthemean.ProbabilityMeanFigure11.2Anormaldistribution.Fromthenormaldistributionweknowthatwehave95percentconfidencethatthefuturepricewillbewithintwostandarddeviationsofthemeaninanormaldistribution.Twostandarddeviationsdownfromthemeanisabout$350,andtwostandarddeviationsupfromthemeanisabout$550sowehaveabout95percentconfidencethatthefuturepriceofgoldwillbesomewherebetween$350and$550.Inourforecastdistribu-tion,alltheresponsesarewithinthatinterval. Derivatives:whatdoyouneedtoknowaboutthem?251Finally,weare99percentconfidentthatthefuturepricewillbewithinthreestandarddeviationsofthemeaninanormaldistribution.Threestandarddeviationsfromthemeanis$150.Weare99percentconfident,oralmostcompletelyconfident,thatthefuturepriceofgoldwillbewithinarangeof$300to$600,thatis$150downfromthemeanand$150upfromthemean.Thesepropertiesofthenormaldistributionprovidepowerfulassistanceinthepricingofderivatives.Whoarethemarketparticipantsinthederivativesmarkets?Inordertounderstandhowtoapplythesearbitrageprinciplesandultimatelyunderstandhowoptionpricesaredetermined,weneedtoexaminetheactionsofthedifferentparticipantsinthemarkets.Inthiscasewechosethegoldmarketbutanyothermarketcouldeasilyhavebeenchosen.Theexpectedfuturepriceofgoldisimportanttoanyonewhousesthegoldspotmarkets,thatisthemarketforimmediatedeliveryorreceiptofgold,andtothegoldfuturesandforwardmarkets,themarketsfordeliveryatsomefuturetimeperiod.Theseuserswouldinclude:A.investorsB.longspeculatorsC.shortspeculatorsD.longhedgersE.shorthedgersF.arbitrageurs.Itisusefultodescribeeachofthesemarketparticipants,discusswhatmotivatestheirmarketbehaviour,andlookathowtheiractionsaffectthespotandthefutureorforwardpriceofanunderlyingcommodityorsecurity.LetuslookfirstatA,ourinvestor.Athinksthatgoldisagoodinvestment,agoldbugintheterminologyofthemarket.Hewantstobuygoldandholditlongterm.WhenAbuysgold,heforcesupthespotpriceofgold.Whenthespotpriceofgoldrises,thefutureorforwardpricetendstoriseaswell. 252EconomicsforFinancialMarketsB,ourlonggoldspeculator,isnotalong-terminvestor,likeA,butshethinksgoldisgoingupandwouldliketotakeapositionthatisgoingtobeprofitableifsheisright.Bcanaccomplishthisinacoupleofdifferentways.First,Bcanbuyspotgold.Ifgoldgoesupinashortperiodoftime,shecansellthatgoldatahigherpriceandmakeaprofit.Alternatively,Bcanbuyafutureorforwardcontractongold.B’spurchaseofforwardgoldtendstomakethefutureorforwardpricegoup;and,justasdemandforspotgoldtendstoraisefutureorforwardprices,demandforforwardgoldtendstoraisespotprices.Aswewillseelater,whenBbuysafutureoraforward,shedoesnothavetopayoutmuchmoney.WhenAbuysspotgold,say100ouncesat$400,hehastopay$40000,immediately.Ourshortspeculator,C,thinksthatthegoldpriceisgoingdown.Sheisverypessimisticabouttheoutlookforgold.LikeAandB,Chastwochoices.Shecansellgoldspot,orshecansellafutureorforwardcontractongold.IfChappenstoowngoldshecansimplysellit.Alternatively,ifsheisinapositiontoborrowgoldrelativelyeasilyandsellitshort,i.e.,tosellgoldshedoesnotphysicallyown,shemightdothat.Butifshedoesnothavedirectaccesstogold,shewillprobablyfinditeasiertosellafutureorforwardcontractongold.ShortspeculatorslikeCaffectthepriceofspotgold.Theeffectonthespotpriceiscleariftheshortspeculatorsowngoldandwanttoshifttheirinvestmenttosomethingelse.Iftheyarenottradinginthespotmarket,thedirecteffectoftheirsalewillbeontheforwardorfutureprice,makingittradeatalowerprice.Dissomeonewhoneedsgoldayearfromnow.Dmightbeadentistorajeweller,someonewhohasallthegoldheneedsrightnowbutwhowantstobeassuredofthegoldpriceayearfromnow.Thereisnoadvantageinbuyingthegoldnowandspendingalargesumofmoneytostoreandinsureit.Dprobablywillwanttobuyafutureorforwardcontractongold,whichwilltendtopushupthefutureorforwardprice.E,ourgoldproducer,isverybusydigginggoldoutoftheground.Hedoesnothavemuchgoldrightnow,butinayearheexpectstohavealargestoreofgoldtosell.Hewantstomakesurehishardworkpaysoffandthathecansellhisgoldatagoodprice.Hecannotsellspotgoldbecausehedoesnothaveit.However,hecansellafutureorforwardcontractongoldnow.Eislikelytoaffectthefutureofforwardprice,andsinceheisselling,hisactionswilltendtomakethefutureorforwardpricetradelower.Ourlastmarketparticipant,thegoldarbitrageur,isthemostimportantinsomeways.Fhasnoopinionaboutgold’s Derivatives:whatdoyouneedtoknowaboutthem?253valueandnoopiniononthelikelydirectionofgoldprices,butsheisveryawareofgoldpricerelationships.EvenifFdidhaveapersonalopinionaboutthevalueofgoldorthedirectionofgoldprices,heropinionwouldnotaffectherfinancialtransac-tions.Fisanarbitrageur,andheractionsinthemarketplacetietheactionsofallothermarketparticipantstogether.Fmakessurethatthespotpriceofgoldandthefutureorforwardpriceofgoldareintheirproperrelationship.Ifthepricesarenotappropriaterelativetooneanother,shewilltrytoprofitbybuyinginthecheapmarketandsellingintheexpensivemarket.Theactionsofarbitrageursareextremelyimportantinseeingthatspotpricesandfuturepricesarekeptinline.Thearbitrageur’sroleandthepricingoffuturesmarketsOneofthereasonsforemphasizingtheroleofthearbitrageurinadiscussionofoptionsisthatarbitrageursareanimportantfactorindeterminingthespot/forwardpricerelationship,andthefirststepinfindingthevalueofanoptionisfindingthevalueoffutureorforwardprices.Ifgoldistradingat$400today,atwhatpricewillsomeoneagreetodaytobuyorsellitoneyearinthefuture?Weusedasurvey,Figure11.1,toforecastthepriceofgoldinayear,butthereisarational,deterministicrelationshipbetweenthespotpriceandtheforwardpriceofgoldthatdoesnotrelyonanopinionsurveyoronanyone’sgoldpriceforecast,itsimplyappliesthearbitrageideasdiscussedabove.Supposethatthecarrycostofgold,thatis,thecostofborrowingmoney,thecostofbuyingthegoldandfinancingitforayear,is10percent.Assumethespotgoldpriceis$400.Holdingthegoldpositionwillcostus10percentforayear,becauseifwehadtoborrowthe$400tobuythegoldwewouldhavehadtopayinterestat10percent.Toowngoldayearfromnow,itwillcostusmorethan$400now.Infactasshownbyequation(11.1),itwillcostus$440.Spotpriceofgold+costofcarry=futureorforwardpriceofgold(11.1)$400+(10%×$400)=$440 254EconomicsforFinancialMarketsIfthepresentvalueofgoldis$400,thefuturevalueofgoldinoneyearshouldbe$440.Byfuturevalue,wedonotnecessarilymeanthepricegoldwillsellforinthefuture;itisthevaluethatthefuturegoldpricehastodaybecauseofthecostofcarryinggoldforayear.Presentvalue,spotvalueandthecashmarketrefertothesamething.Wehavebeentalkingaboutspotgold,butwecanalsotalkaboutthespotvalue,currentmarketvalueorcashvalueofastock,abond,orsomeotherunderlyingcommodityorfinancialinstrument,tobroadenthefuturespricingprinciples.Futurevaluereferstothevalueofthefutureortheforward.Thereisadifferencebetweenfuturesandforwards,butthedifferenceisinhowtheyaretraded,notinhowtheyarevalued.Atthispointwewilltreatfuturesandforwardsasthoughtheywereinterchangeable.Later,wewilldiscussthepracticaldifferencesbetweenfuturesmarketsandforwardmarkets.Whatarethefactorsinfluencingthepriceoffutures?Tradersinanycommodity,sayawheatbuyer(breadmaker),orawheatseller(wheatfarmer),fearingwheatpricevolatility,areanxioustouseacashmarkethedgetohedgewheatpricerisk.Afuturescontractisaderivativeofthisspotmarkethedge.Asellerofwheatwillnotwishthepricetofallinthefuturewhenasaleisanticipated.Abuyerofwheatwillnotwishthepricetorisewhenapurchaseisanticipated.Ifanagreementismadetodeliveraquantityandgradeofwheatinthreemonths’time,howmightthesellerofthewheatarrangeaffairssothatthereisnopricerisk?Iftheyremaininanopenposition,i.e.,notowningthewheat,thereisnoknowingwhatthepriceofwheatwillbeinthreemonths’time.Thereforeacashmarkethedgecanbeconstructedasfollows.Wheatwillalreadybeheldorcanbepurchasedattoday’sspotprice.Taketoday’sspotprice,whichisknown,andaddtothisthecostofcarryingthewheatforthreemonths.Thesecarrycostswillbe:storageinsurance Derivatives:whatdoyouneedtoknowaboutthem?255transportcostsinvolvedinmakingdeliverytoanamedplacefinancingcostsoftheoperationoverthethreemonths,i.e.,interestforegone,orinterestpaidonfundsusedtopur-chasethecommodity.Thisgivesusthefollowingrelationshipbetweenthespotandfuturesprice:spotwheatprice+thecostofcarry=agreedpriceofwheatin3months’time(i.e.,futuresprice)Suchastrategywillfixthepriceofwheatforbothpartiesin3months’time.Regardlessofwhathappenstothespotpriceduringthe3months,theagreedpricewillbereceivedorpaid.FuturespricingApriceinthefuturesagreementorcontracthastobeagreed.Thequestionariseswhatmust/shouldthispricebe?Theprice,asindicatedabove,‘should’betoday’sspotpriceadjus-tedbythecostofcarryforthreemonths.Ifyouagreethispricewithyourcounterpartythiswillbecometheentryprice,asitisknown.Iftheentrypriceisnot‘correct’,thenanarbitragecanbemade,asillustratedbelow,usingthecashmarkethedgedescribedaboveandthesimultaneousmis-pricedfuturesagreement.Iftheentrypriceofthefuturescontract(rememberthiswillgivethesellerofwheattherighttosellthewheatatthisagreedentrypriceinthreemonths’time)isgreaterthanspotpluscostofcarry,thenanarbitrageprofitispossible.Inthisexample,thefuturespriceissaidtobe‘rich’tothecashprice,soontheprinciplethatyousellthatwhichisoverpriced(thefuture)andbuythatwhichisunderpriced(commodityatspot),itfollowsthatiffuture(entry)price>spotpluscostofcarry(e.g.$10>$8+$1.50)thenarbitrageursinthespotmarketwilltakealongposition,i.e.,purchasewheatatthespotrateandcarrythisforthreemonths. 256EconomicsforFinancialMarketsTheirtotaloutlay=spotpriceplusthecostofcarry$9.50=$8+$1.50Inthefuturesmarkettheywilltakeashortposition,i.e.,sellafuturescontract.Inthreemonths’timetheywillsellthegoodsheldoverthethreemonthsatatotaloutlayoforiginalspot($8)pluscostofcarry($1.50),forasumgreaterthanthis,($10)asenabledbythefuturescontractheld,because:futurecontractprice>spotpricepluscostofcarry$10>$8+$1.50Thisarbitrageprocessiscalledacashandcarrytransaction.Inthisexamplearisk-freeprofitisbeingmade.Thearbitrageopportunitywillbeerodedanddisappearassuchtransactionsaremade.Demandatthespotpricewillraisethespotpricesothatthis,whenaddedtothecostofcarry,equalsthefuturesprice.Atthesametimetherewillbeagreaterdemandforshortpositionsinfuturesandthiswilldrivedownthefuturesprice.Inbothmarketsthetendencywillbetoequalizeprices.Ifthefuturespriceequalsthespotpriceplusfullcarryingcost,thenthefuturespricewillbewhatisknownasafullcarryprice.Ifthefuturespriceis‘cheap’,thenarbitrageursbuywhatischeap(thefuturesmarket)andsellthatwhichisexpensive(thespotprice).Thisarbitrageagain‘should’resultinafullcarryfuturesprice.Attheendofeitherofthesetransactionsthefuturesentrypriceshouldequalthespotpriceplusthecostofcarry.Theprincipleemergesthereforethatspotandfuturepricesdifferduetotheprincipleofcostofcarry.However,atmaturityspotandfutureswillbeidentical.Iftheyarenotidenticalitwillbepossible,afractionoftimebeforematurity,totakeafuturespositionandanoppositecashmarketposition,arbitrageandprofitfromthedifference.Asimpleexampleillustratesthis.Saythefuturespriceis$10andthespotpriceis$8.Sellingafuturescontract(righttodeliverat$10)andbuyinginthespotmarketat$8obviouslygivesaprofitof$2perunitquantity.Ifpricesareidenticalatmaturity,butdifferatthebeginningoftheperiod,itfollowsthatevenifthespotpriceweretoremainconstant(highlyunlikely)thefuturespricewouldgraduallyhavetochangeasthecontractapproachedmaturity.Toillustratethiswemustfirstdefinewhatinthederivativesmarketisknownas‘basis’. Derivatives:whatdoyouneedtoknowaboutthem?257Whatisbasis?Basisisthedifferencebetweentheforwardorfuturevalueandthespotvalue.Formanyproducts,thebasisisdefinedasthecostofundertakingthetransactionminusthebenefitofundertakingthetransaction,i.e.,holdingtheunderlyingsecu-rity.Thisgivesthefollowingrelationship:basis=costoftransaction–benefitfromthetransactionInourgoldfuturespricingexample,weconsideredonlythefinancialcostofcarryinggoldat10percent,becausetherearenoeconomicorfinancialbenefitsfromowninggold.(Itmightgiveyouafeelingofcomforttoowngold,butwearenotcountingthat.)Insomeotherproducts,therearebenefitstoholdingfinancialinstrumentsaswellascosts,aswillbeseenbelow.Shouldwenowconsiderthefuturesmarketsforstockswemustagainconsiderthecostofcarry,i.e.,thecostofthemoneytobuythestock,butwemustnowalsoconsiderthepossiblebenefitofholdingstocks,i.e.,thepossibilityofreceivingacashdividend.Notallstockspaydividends,butiftheydo,thedividendisabenefit.Incurrencymarkets,thecostofcarryingaforeigncurrencyistheinvestor’sdomesticinterestrate.IfaUSdollar-basedinvestorwantseuros,shehastogiveupdollarstobuytheeuros.Whenshegivesupthedollars,sheeithertakesthemoutofaninterest-bearingaccount,whichmeansshelosestheinterestincome,orsheborrowsthedollarsfromabankandpaysdomesticinterest.Eitherwayshehasacarrycostinthedomesticcurrency,andthatisthedollarcost.Ontheotherhand,whenshegetstheeuros,shecaninvesttheminaeuroaccountandearninterestateurorates.Theinterestontheeuroaccountisabenefitofowningtheeuros.Letusnowturntothebondmarket.Often,tradersorportfoliomanagershavetoborrowmoneytocarrybonds.Theyborrowmoneyintherepo(repurchaseagreement)market,postingthebondsascollateralfortheloan.Thereporateisthetermusedfortheinterestratechargedonsuchaloan.Ontheotherhand,whiletheyownthebondtheyareentitledtoanycouponinterestthataccumulates.Forabond,thereporateisthecarrycostofthebond,andthecouponinterestisthebenefit.Thebasisineachoftheseexamplesconsistsofthecostofholdingtheinstrumentorcommodityminusthebenefitof 258EconomicsforFinancialMarketsowningtheunderlyinginstrumentorcommodityfromthespotdatetotheforwarddate.Whatisthebasisfordifferentinstruments?Forgold,thebasisissimplytheinterestcostofcarryingthegold.Forastock,thebasisistheinterestcostofcarryingthestockminusthedividendsearnedfromthestock.Foracurrency,thebasisisthecostoftheinterestonthedomesticcurrencyminusthebenefitoftheinterestearnedontheforeigncurrency.Forabond,thebasisisthecostofborrowingatthereporateminusthebenefitofthecouponpayment.SpotversusforwardarbitrageApplyingtheideaofbasistoarbitrageexampleswillhelptoclarifysomespotandforwardpricingrelationships.Supposethatgoldistradingfor$400,andtheforwardprice,whichwesaidearliershouldbetradingat$440,istradingat$450.Itwillcostus$400plus10percentof$400tobuygoldandcarryitforoneyear.Thatmeanswecanbuygoldtodaybyborrowingmoneyfromthebank,andinoneyearwehavetorepaythebank$440.Withthegoldforwardtradingtodayfor$450,wecansellitandmakeaprofit.Inoneyear,wedotwomoretransactions:(1)delivergoldfor$450anouncetocompletetheforwardcontract,and(2)repaythebank$440anounce,givinganetdifferenceof$10profit.Withaspotpriceof$400andaforwardpriceof$450,wecanbuygoldtodayandsellitforward,makingacertainprofitof$10perounce.Thisisarisklessprofit,anarbitrageprofit,whichwemakebysimultaneouslybuyingandsellingequiva-lentinstruments.Letuslookatthistransactionfromadifferentperspective.Itmayseemasthoughweboughtgold,butbecauseweboughtgoldbyborrowingmoneyandcarryingitforayear,weeffectivelyboughttheforward,paying$440anouncetoowngoldinoneyear.Simultaneously,wesoldtheactualforward,theonethatistradeable,for$450.Theseareequivalentinstruments,andtheyshouldbepricedidentically.Whenequivalentinstrumentsdonottradeatthesamepriceanarbitrageprofitcanbemade. Derivatives:whatdoyouneedtoknowaboutthem?259Supposethatspotgoldistradingat$400andforwardgoldistradingat$420–lowerthanthe$440forwardpricewecalculatedearlier.Forwardgoldat$420soundslikeabargain;letusbuytheforwardandsimultaneouslysellthespottomakeacertainprofitof$20.Ifwedonotowngold,wemustborrowitandsellitfor$400,orsellshortspotgold.Wecantheninvestthe$400fromthesaleofthegold.Thebankwillpayus10percentinterest,andwewillhave$440inthebankayearlater.Then,wewilldotwomoretransactionstocloseoutthearbitrage:(1)withdrawmoneyfromthebankat$440anounce,and(2)acceptdeliveryofforwardgoldat$420anounce,givinganetdifferenceof$20profit.Wehavetoreturnthegoldweborrowed,andourprofitmaybereducedifwehavetopayafeeforborrowingthegold.Inthefirstexample,thegoldforwardwasexpensivecomparedtothe$440itwouldcostustobuygoldandcarryitforayear.Sowesoldforwardgold,boughtspotgold,andcarrieditforayear.Inthesecondexample,thegoldforwardwascheap,soweboughtfor-wardgold,soldspotgold,andearnedinterestonabankdeposit.Inbothcases,wearbitragedaprofitwithnopricerisk.Infact,weexchangedpriceriskforbasisrisk.Itisimportanttoemphasizethat,inbothcases,forwardtransactionswereagreedonatthebeginningoftheperiod,andactualtransac-tionsweredoneattheendoftheperiod.Regardlessofwhatanyinvestorthinksthepriceofgoldwillbeinayear,theactionsofarbitrageurs,i.e.,thepeoplewhomonitortherelationshipsbetweenthespotandtheforward,willensurethatthespotpriceandtheforwardpricehavetheappropriatecashandcarryrelationshiptoeachother.Thatdoesnotmeanthearbitrageursdeterminethevalueofthespotorthevalueoftheforward.Whilehedgers,speculators,andinvestorsaffectthespotpriceortheforwardprice,arbitrageursensurethatthecashandcarryrelationshipbetweenthespotandforwardispre-served.Wehaveemphasizedthisrelationshipbecauseknowinghowtovaluefuturesandforwardsrelativetothespotpriceisthefirststeptowardsknowinghowtovalueoptions.Whatareforwardmarketcontracts?Aforwardcontractisanagreementbetweentwopartiesmadeindependentlyofanyorganizedexchangemarket.Nobodyother 260EconomicsforFinancialMarketsthanthepartiestotheforwardagreementneedstobeinvolved;therearenoformalrulesoutsidetheagreementbetweenthetwoparties.Theforwardcontractisastand-alone,customizedcontract.Itcanbebasedonanyamountofanygood.Itcanbewrittenforsettlementatanytimeandatanyprice.Itcanbe,asanextremeexample,fordeliveryof37000gallonsofvodkain52daysat$2agallon.Thetermscanbevirtuallyanythingaslongasbothpartiesagreetothem.Onepartyagreestosellthevodkaatthecontractprice,andtheotherpartyagreestobuyitatthatprice.Sincethecontractcanbeforanyamountofanygood,atanytimeandatanyprice,andsinceeachpartydependsontheotherpartytomeetcontractualobligations,theforwardcontractcannotbetradedfreelywithotherpotentialcounterparties.Forwardsarenotfungible,i.e.,oneforwardcontractisnotinter-changeablewithanothercontractthathassimilarterms,andthepresentvalueoftheforwardcontractisnoteasilycon-vertedtoacashmarketvalue.Eachpartyhastobeabletotrustthattheotherpartywillupholdhissideoftheagreement,becausethetwocounter-partiesareexposedtoeachother’sabilityandwillingnesstoperformonthecontract.Thereiscreditriskassociatedwithaforwardcontract,whichmustbecontrolled.Thisisbasedinthefactthatyoucannotbesurethatthecounterpartywilldeliverasagreed.Often,thecreditriskiscontrolledbybanks,whichactasintermediaries,assuringtheperformanceoftheirclients.Averyimportantpointtorememberaboutforwardcontractsisthatnomoneyisexchangedbythepartiesuntiltheactualexchangeofgoodsorfinancialinstrumentsatsettlement.Thereisnormallynointerimcashflow.Whatarefuturescontracts?Afuturescontract,incontrasttoaforward,isanagreementbetweentwopartiesmadethroughtheiragentsonanorga-nizedfuturesexchange.Thepartieswhotradeontheexchangecanrepresentthemselvesortheycanrepresentcustomers.Therearespecificrulesandregulationsthatsetthetermsofthecontractandtheproceduresfortrading.Thecontractisforaspecificamountofaspecificgoodtobedeliveredataspecifictimedeterminedbytheexchange.Thepricediscovery,asfixingthepriceisoftenreferredto,isusually,butnotalways,determinedbyopenoutcryina Derivatives:whatdoyouneedtoknowaboutthem?261tradingpit,i.e.,bypeopleyellingandscreamingpricesateachotherinaroom.Thisisthewaypricesarediscoveredandgoodsareexchan-gedinmanyefficientmarkets.Somemarketsnowusecom-putersystems,knownasscreen-basedtrading,whichexposebidsandofferstoalargenumberofpotentialtradersatmanylocations,buttheprincipleofbringingbidsandofferstogetheristhesame.Severalfeaturesoffuturesmarketsareworthnoting.First,afuturescontractisalwaysforaspecificamountofaspecificgood.Wecannotsetoutourowncontractamount,say37000gallonsofvodka.Ifthevodkacontractsetbytheexchangeis20000gallons,wecantradeanynumberofcontracts,buteachcontractmustbefor20000gallons.Andwemustspecifythetypeofvodka;itmustbeFinlandiavodkaorStolichnayavodka,or,morelikely,simply80-proofvodka.Sincealltermsaredeterminedinthefuturescontract,thecontractscanberetradedfreelywithothercounterparties.Wecanbuythecontractfromoneperson,sellthecontracttoanother,andwashourhandsofthecommitment.Wecaneliminateourobligation,because,withfutures,theorganizedfuturesexchangehandlingthetransactiontakestheothersideofthecontract.Thefuturesexchangeistheultimatecounterpartyforallfuturestrades,sotheonlycreditriskisthecreditworthi-nessoftheexchange,whichisnormallyverylow.Onceatradeiscompleted,thetransactionispassedtosometypeofexchangeclearingcorporation.Thefuturescontractbuy-ersandsellershaveagreementwiththeclearingcorpora-tion.Ultimately,ifatradertakesdeliveryratherthanoffsetsthecontract,i.e.,reversesit,theexchangewillselectsomeonewhoisshortthecontract,i.e.,hasagreedtosell,tomakedelivery.Thepartymakingdeliverydoesnothavetobethepartywhosoldthecontractoriginally.Afterthetradesettles,theoriginalpartiestothetradeloseanydirecttietoeachotherbasedonthetrade.Nocreditintermediaryisnecessary,butmarginmustbedepositedtoensureeachpartymeetsitsobligations.Theexchangeclearingcorporationhastostandbehindthecreditworthinessofitsmembers,soitaskseveryoneforadeposit.Customersmakeadepositwiththeirbroker,knownasmargin,andthebrokerpassesthedeposittotheclearingcorporation.Futuresmarginisagoodfaithdeposit, 262EconomicsforFinancialMarketsTable11.2TheadvantagesanddisadvantagesoffuturesandforwardsFuturesmarketsForwardmarketsDefaultrisk+Low–GreaterthanforfuturesTransactioncosts/+Low–HigherthanforfuturescommissionsStandardization+Contractsareliquid;–Nosecondarymarketallowsforsecondarymarket–Imperfecthedge+TailormadehedgeInterestraterisk–DailycashflowsfromNotapplicablemarkingtomarketmustbedepositedatunknowninterestratesContractsizesand–LimitednumberofunderlyingcurrenciescontractsandunderlyingsecuritiesmakeshedgingwithfutureslesseffectiveMaturities–Shortmaturityonly+Slightlylongertomuchlongermaturitiesthanforfuturesdemonstratingabilityandwillingnesstomeetcontractualobligations.Table11.2illustratestheadvantagesanddis-advantagesoffuturesandforwardcontracts.Howareoptionspriced?Themethodusedtopriceoptionsdependsonthetypeofoptionbeingpriced.AscanbeseenfromTable11.3thetwopricingTable11.3EuropeanversusAmericanoptionsTypeofoptionExercisedatePricingmodelAmericanoptionAnytimeuptomaturityCox,RubinsteinandRossEuropeanoptionAtmaturitydateBlack–Scholes Derivatives:whatdoyouneedtoknowaboutthem?263modelsarethebinomialmodelusedforAmericanoptions(whichwasdesignedbyCox,RossandRubinstein),andtheBlack–Scholesoptionpricingmodel,usedforpricingEuropeanoptions.AsweshowbelowthebinomialmodelcanalsobeusedtopriceEuropeanoptions.Thekeytovaluingoptionsistodesignarisk-freeportfolioinwhichthevaluedoesnotchangewhenthereisachangeintheunderlyingasset.Thisrisk-freeelementisachievedbydesign-ingaportfoliothatreplicates,i.e.,oneinwhichthepay-offsoftheportfolioexactlymatchthepay-offsoftheoption.Agoodexampleofthisisachievedbyapplyingthebinomialmodel.ThebinomialmodelOne-periodbinomialmodel:theroleofthereplicatingportfolioToillustratethebinomialmodelitisnecessarytolookatwhattheeffectofthepricesoftheunderlyingstockrisingorfallinginpriceshouldhaveontheoptionprice.OurfirstexampleisaEuropeancalloptiononastock,andassumesthatthestockiscurrentlyvaluedat$100.Inthisexamplethereisanoptiontopurchasethisstockandthisexpiresinoneyearandthestrikeorexercisepriceis$100.Theannualrisk-freeinterestrateis5percent,sothatborrowing$1todaywillmeanhavingtopayback$1.05oneyearfromnow.Forsimplicity,theassumptionhereisthatthereareonlytwopossibleoutcomeswhentheoptionexpires:thestockpricecanbeeither$120(anupstate),or$80(adownstate).Notethatthevalueofthecalloptionwillbe$20iftheupstateoccursand$0ifthedownstateoccursasshownbelow(seeFigure11.3).Inotherwordsifthepricefallsto$80theoptionbecomesvalueless.Sincethereareonlytwopossiblestatesinthefutureitispossibletoreplicatethevalueoftheoptionineachofthesestatesbyformingaportfolioofthestockandarisk-freeasset.If,anunknownnumberofsharesofthestockarepurchasedandM,anunknownamountofdollarsareborrowedattherisk-freerate,thestockportionoftheportfolioisworth120×intheupstateand80×inthedownstate,while1.05×Mwillhavetobepaidbackineitherofthetwostates.Thus,tomatch,orreplicate,thevalueoftheportfoliotothevalueoftheoptioninthetwopossiblestates,itmustbethecasethat 264EconomicsforFinancialMarkets$120×–1.05×M=$20(upstate)(11.2)and$80×–1.05×M=$0(downstate)(11.3)Byrearrangingtheformulaefromequations(11.2)and(11.3)thisgivesusavaluefor.$40=20=0.5Inserting=0.5inequation(11.2)givesus$120×0.5–1.05M=$20$40=1.05MSoM=$38.10TheresultingsystemoftwoequationswithtwounknownsandM,solvedabove,givesus=0.5,andMisapproximately$38.10.Therefore,onewouldneedtobuy0.5sharesofthestockandborrow$38.10attherisk-freerateinorderforthevalueoftheportfoliotobe$20and$0intheupstateanddownstate,respectively.Equivalently,selling0.5sharesofthestockandlending$38.10attherisk-freeratewouldmeanpay-offsfromthatportfolioof$20and$0intheupanddownstaterespectively,whichwouldcompletelyoffsetthepay-offsfromtheoptioninthosestates.Thisisapowerfulfindingasitenablesustoreplicatetherisk-freeportfolioandpricetheoptionsaccordingly.Itisalsoworthnotingthatthecurrentvalueoftheoptionmustequalthecurrentvalueoftheportfolio,whichis100×–M=100×0.5–M=$11.90.Inotherwords,StockvaluesOptionvalues$120$20(upstate)$100$?$80$0(downstate)TodayOneyearTodayOneyearFigure11.3Stockandoptionvaluesintheone-periodmodel. Derivatives:whatdoyouneedtoknowaboutthem?265acalloptiononthestockisequivalenttoalongpositioninthestockfinancedbyborrowingattherisk-freerate.Thevariableiscalledthedeltaoftheoption.Inthepreviousexample,ifCuandCddenotethevaluesofthecalloptionintheupanddownstates,withSuandSddenotingthepriceofthestockintheupanddownstates,respectively,thenitcanbeverifiedthat=(Cu–Cd)/(Su–Sd).Thedeltaofanoptionrevealshowthevalueoftheoptionisgoingtochangewithachangeinthestockprice.Forexample,knowingboth=Cd,andthedifferencebetweenthestockpricesintheupanddownstate,itmakesitpossibletoknowhowmuchtheoptionisgoingtobeworthintheupstate,i.e.,Cuisalsoknown.Thetwo-periodbinomialmodelAmodelinwhichayearfromnowthereareonlytwopossiblestatesoftheworldiscertainlynotrealistic,butconstructionofamultiperiodmodelcanalleviatethisproblem.Theone-periodmodelassumesareplicatingportfolioforacalloptiononastockcurrentlyvaluedat$100withastrikepriceof$100andwhichexpiresinayear.However,letusnowassumethattheyearisdividedintotwosix-monthperiodsandthevalueofthestockcaneitherincreaseordecreaseby10percentineachperiod.Thesemi-annualrisk-freeinterestrateis2.47percent,whichisequivalenttoanannualcompoundedrateof5percent.ThestatesoftheworldforthestockvaluesaregiveninFigures11.4and11.5.Giventhisstructure,howdoesonebuildaportfolioofthestockandtherisk-freeassettoreplicatetheoption?Thecalculationissimilartotheoneaboveexceptthatitisdone$121$21$110$12.78$100$99$7.77$0$90$0$81$0Today6months1yearToday6months1yearFigure11.4Stockvaluesinthetwo-Figure11.5Optionvaluesinthetwo-periodmodel.periodmodel. 266EconomicsforFinancialMarketsrecursively,startingoneperiodbeforetheoptionexpiresandworkingbackwardstofindthecurrentposition.Inthecaseinwhichthevalueofthestockoverthefirstsixmonthsincreasesby10percentto$110(i.e.,theupstatesixmonthsfromnow),thevalueoftheoptionintheupstateisfoundbyformingareplicatingportfoliocontainingusharesofthestockfinancedbyborrowingMudollarsattherisk-freerate.Overthenextsixmonths,thevalueofthestockcaneitherincreaseanother10percentto$121ordecline10percentto$99,sothattheoptionatexpirationwillbewortheither$21or$0.Sincethereplicatingportfoliohastomatchthevaluesoftheoption,regardlessofwhetherthestockpriceis$121or$99,theequations(11.4)and(11.5)mustbesatisfied.$121×u–1.0247×Mu=$21(11.4)and$99×u–1.0247×Mu=$0(11.5)Solvingtheseequationsresultsinu=0.9545andMu=92.22.Thusthevalueofthereplicatingportfoliois110×u–Mu=$12.78.Ifinstead,sixmonthsfromnowthestockdeclines10percentinvalue,to$90(thedownstate),thestockpriceattheexpirationoftheoptionwilleitherbe$99or$81,whichislessthantheexerciseprice.Thustheoptionisworthlessayearfromnowifthedownstateisrealizedsixmonthsfromnow,andconsequentlythevalueoftheoptioninthedownstateiszero.Giventhetwopossiblevaluesoftheoptionsixmonthsfromnow,itisnowpossibletoderivethenumberofsharesofthestockthatoneneedstobuyandtheamountnecessarytoborrowtoreplicatetheoptionpay-offsintheupanddownstatesixmonthsfromnow.Sincetheoptionisworth$12.78and$0intheupanddownstates,respectively,itfollowsthat$110×–1.0247×M=$12.78(11.6)and$90×–1.0247×M=$0(11.7)Solvingequations(11.6)and(11.7)resultsin=0.6389andM=$56.11.Thusthevalueoftheoptionpricetodayis100×–M=$7.77.ThevaluesofthestockoptionareshowngraphicallyinFigures11.4and11.5.Afeatureofthisreplicatingportfolioisthatitisalwaysself-financing.Onceitissetup,nofurtherexternalcashinflowsoroutflowsarerequiredinthefuture.Forexample,ifthe Derivatives:whatdoyouneedtoknowaboutthem?267replicatingportfolioissetupbyborrowing$56.11andbuying0.6389sharesofthestock,andinsixmonthstheupstateisrealized,theinitialportfolioisliquidated.Thesaleofthe0.6389sharesofstockat$110pershare,nets$70.28.Repayingtheloanwithinterest,whichamountsto$57.50,leaves$12.78.Thenewreplicatingportfoliorequiresborrowing$92.22.Com-biningthisamountwiththeproceedsof$12.78gives$105,whichisexactlyenoughtobuytherequired0.9545usharesofstockat$110pershare.Replicatingportfoliosalwayshavethisproperty:liquidatingthecurrentportfolionetsexactlyenoughmoneytoformthenextportfolio.Thustheportfoliocanbesetuptoday,rebalancedattheendofeachperiodwithnoinfusionsofexternalcash,andatexpirationshouldmatchthepay-offoftheoption,nomatterwhichstatesoftheworldoccur.Inthereplicatingportfoliopresentedabove,theoptionexpireseitheroneortwoperiodsfromnow,butthesameprincipleappliesforanynumberofperiods.Given,inthisexample,thatthereareonlytwopossiblestatesovereachperiod,aself-financingreplicatingportfoliocanbeformedateachdateandstatebytradinginthestockandarisk-freeasset.Asthenumberofperiod’sincreases,theindividualperiodsgetshortersothatmoreandmorepossiblestatesoftheworldexistatexpiration.Inthelimit,continuumsofpossiblestatesandperiodsexistsothattheportfoliowillhavetobecontinuouslyrebalanced.TheBlack–Scholes–Mertonmodel,discussedbelow,isthelimitingcaseofthesemodelswithalimitednumberofperiods.Whatdeterminesthevalueofcalloptions?Acalloptionistherighttopurchasetheunderlyingassetforaspecifiedexercisepriceuntiltheexpirationdate.Asdiscussedearlier,Americanoptionscanbeexercisedatanytime.Euro-peanoptionscanbeexercisedonlyattheexpirationdate.Inthediscussionbelow,whichdrawsonLivingston(1995)thefollow-ingnotationisused.CisthemarketvalueofthecalloptionPisthemarketvalueoftheunderlyingassetEistheexerciseprice(strikeprice). 268EconomicsforFinancialMarketsIfthepriceoftheunderlyingasset(P)islessthantheexerciseprice(PE),thecalloptionisdescribedasbeingin-the-money.Whatisthevalueofthecalloptionatexpiration?Atexpiration,thevalueofthecalloptionmustbezeroifthemarketvalueoftheunderlyingassetislessthanorequaltotheexerciseprice.Norationalinvestorwouldexerciseacalloptioniftheunderlyingassetsellsfortheexercisepriceorlesssincebuyingtheunderlyingsecurityintheopenmarketwouldbecheaperthanexercisingthecalloption.Forexample,inTable11.4,ifabondsellsfor$90intheopenmarket,acalloptionwithanexercisepriceof$100isvaluelessatexpiration.Insteadofexercisingthecallandpayingthe$100exerciseprice,itispreferabletobuythebonddirectlyfor$90.Table11.4ValueofCallOptionatExpiration(E=$100)PEe.g.P=90P=100P=110C=0C=0C=P–Ee.g.C=10out-of-the-moneyat-the-moneyin-the-moneySource:Livingstone(1995)InTable11.4,ifthepriceoftheunderlyingassetexceedstheexerciseprice,thecalloptionisworththepriceoftheunderlyingassetminustheexerciseprice,i.e.,P–E.TheamountP–Eiscalledtheintrinsicvalueofacalloption.IfthecalloptionsellsforlessthanP–E,anarbitrageurwouldbuythecall,exerciseit,andmakeanarbitrageprofit.Atexpiration,buyingthecalloptionfor$Candexercisingitisequivalenttobuyingtheunderlyingsecuritydirectlyfor$P.Thus,P=C+E,orC=P–E.Atexpiration,thevalueofacalloptionis:C=0ifP≤Eat-orout-of-the-money(11.8)C=P–EifP>Ein-the-money(11.9) Derivatives:whatdoyouneedtoknowaboutthem?269Whatisthevalueofthecalloptionbeforeexpiration?Withtimeleftuntilexpiration,anAmericancalloptionhasavaluegreaterthananotherwiseidenticalexpiringcalloption.Table11.5illustratesthepossibilities.Beforeexpiration:C>0ifP≤Eat-orout-of-the-money(11.10)C>P–EifP>Ein-the-money(11.11)Iftheseconditionsdonothold,arbitrageopportunitiesareavailabletoinvestors.Forout-of-the-moneycalloptions,azeropriceallowsanarbitrageurtobuythecallfornothing.Ifthecallexpiresworthless,thearbitrageurlosesnothing;ifthecallendsupin-the-money,thearbitrageurhasanetprofit.Toeliminateprofitablearbitrage,themarketvalueofthecalloptionmustbepositive.Table11.5ValueofCallOptionbeforeExpiration(E=$100)PEe.g.P=90P=100P=110C>0C>0C>P–Ee.g.C>10Source:Livingstone(1995)Forin-the-moneycalloptions,apricelessthantheunder-lyingassetpriceminustheexerciseprice(P–E)allowsanarbitrageurtobuythecalloptionforCandexerciseitforE,foratotalcostofC+E.TheacquiredsecurityisthensoldforitsmarketvalueP,which,byassumption,isgreaterthanC+EforanarbitrageprofitofP–(C+E).Toeliminatearbitrageprofitopportunities,C+EmustbeequaltoorexceedP,meaningthatCmustbegreaterthanorequaltoP–E.Forexample,ifabondsellsfor$110andifacalloptionwith$100exercisepricesellsfor$5,anyonecouldbuythecallfor$5,exerciseitfor$100,andselltheresultingbondfor$110forasureprofitof$5.Thepriceoftheunderlyingsecurityisalogicalupperboundforthepriceofacalloption.Nooneshouldlogicallypaymoreforanoptiontobuyasecuritythanthepricetopurchasethesecurityoutright.Ifabondissellingfor$100,alogicalperson 270EconomicsforFinancialMarketswouldneverpaymorethan$100foracalloption.Theinvestorisbetterofftobuytheunderlyingassetdirectlyinthemarketitself.Whatistheprofitprofileforacalloption?Thepossiblevalueofacalloptioncanbeseenfromaprofitprofile.Asareferencepoint,considersomeonewhobuysabond(forwhichoptionstrade)currentlysellingatitsexercisepriceof$100andholdsthisbondforthreemonthsuntiltheoptionexpires.Thepossibleprofitsandlosses,overlookingcouponinterest,areshownasasolidlineinFigure11.6.ProfitBuyunderlyingsecurityWritecallBuycall+4100Underlying1040assetatEexpiration-4LossFigure11.6Profitprofilesforacalloption(source:Livingstone,1995).Considerthepurchaseofacalloptionfor$4withanexercisepriceof$100.Theinvestorholdsthiscalloptionforthreemonthsuntilexpiration.TheprofitprofileisshownasthedottedlineinFigure11.6.Thefirststepindrawingtheprofitprofileistocomputetheprofitandlossonthepositionforseverallevelsofthepriceoftheunderlyingatexpiration.Thesepricesshouldincludetheoption’sexercisepriceandseveralpointsoneithersideoftheexerciseprice.Theproce-dureisillustratedinTable11.6. Derivatives:whatdoyouneedtoknowaboutthem?271Table11.6ProfitsoflossesforaCallBuyer(E=$100)PriceofUnderlyingSecurityatExpiration98100102104Buycall(C)–4–4–4–4Exercisecallatexpiration–100–100Sellunderlyingbondacquired+102+104fromexercisingoptionNetprofit=+C–E+P–4–4–20Source:Livingstone(1995)Thecallbuyersuffersalossof$4,theentirepurchase,ifthebondpriceisbelowtheexercisepriceof$100.This$4isthemaximumlossforthebuyerofacalloption.Ifthebondpriceatexpirationisabovetheexerciseprice,theprofitequalsP–E=$4.Anetlossisincurredifthebondpriceisbelow$104andanetprofitifthebondpriceisabove$104.Theprofitprofileindicatesthatcallbuyersareanticipatingarisingpricefortheunderlyingasset.Ifthebondpriceisatorbelowtheexerciseprice,theprofitprofileshowsthecallbuyer’smaximumlosstobethepurchaseprice,C.Sincethiscallpurchasepriceisasmallpercentageofthebondprice,thelossfrombuyingacallissmallinabsolutedollarscomparedtothelossfrompurchasingthebondoutright.Ontheotherhand,thecallbuyergainssubstantiallyifthebonddoeswell.Foreveryonewhobuysacalloption,someonesellsorwritesthecall.Thecallwriteragreestoselltheunderlyingassetattheexercisepriceiftheoptionisexercisedbythecallbuyer.Calloptionsareazero-sumgame,meaningthatthecallbuyer’sgainsarethecallwriter’slossesandviceversa.Ineffect,thebuyerandthewriterarebettingagainsteachother.TheprofitsorlossesforacallwriterintheearlierexampleareshowninTable11.7.TheprofitprofileforthecallwriterisshowninFigure11.7.Ifthecallisout-of-the-moneyatexpiration,thecallwriterbenefitsbytheoriginalsalepriceofthecall.Foreverydollarthattheunderlyingassetrisesabovetheexerciseprice,thecallwriter’sprofitisreducedby$1. 272EconomicsforFinancialMarketsTable11.7ProfitsorLossesforCallWriter(E=$100)PriceofUnderlyingSecurityatExpiration98100102104Writecall+4+4+4+4Sellunderlyingbondatcall+100+100priceatexpirationSellunderlyingbondinthe–102–104openmarketNetprofit=+C+E–P+4+4+20Source:Livingstone(1995)PutoptionsAputoptionistherighttosellasecurityatastatedexercisepriceEduringastatedtimeinterval.Whatisthevalueofputoptionsatexpiration?Toseethevalueofaputoption,considerthepossiblepay-offsatexpirationforthebuyerofaput(seeTable11.8).ThepriceofaputisdenotedbyPp.Atexpiration,ifthepriceoftheunderlyingsecurityequalsorexceedstheexerciseprice(P>E),theputhasnovalue,sincenoinvestorwouldchoosetoselltheunderlyingassetatEwhenthehighermarketpriceofPisavailable.Ifabondsellsat$110andifthereisaputoptionwith$100exerciseprice,exercisingtheputTable11.8Valueofputoptionbeforeexpiration(E=$100)PEe.g.P=90P=100P=110Pp=P–EPp=0Pp=0e.g.Pp=10Source:Livingstone(1995) Derivatives:whatdoyouneedtoknowaboutthem?273optioninvolvessellingthebondattheexercisepriceof$100.Foranyrationalinvestor,sellingthebondatitscurrentmarketpriceof$110ispreferable.Noonewouldexercisetheputoption.Atexpiration,theputoptionexpiresworthless.Atexpiration,iftheunderlyingassetpriceislessthantheexerciseprice,theputhasvalue,sinceitrepresentstherighttoselltheunderlyingassetatE,whichisabovethecurrentmarketprice.Clearly,theputisworththedifferenceE–P.Forexample,ifabondsellsfor$80,aputoptionwitha$100exercisepriceisworth$20atexpiration.Iftheputsellsfor$15,anarbitrageurcanbuytheputfor$15,buythebondfor$80,andsellthebondfor$100byexercisingtheput.Thereisasureprofitof$5.Atexpiration,thevalueofaput,Pp,mustbe:Pp=0ifP≥Eat-orout-of-the-money(11.12)Pp=E–PifPE–PifPEe.g.P=90P=100P=110Pp>E–PPp>0Pp>0e.g.Pp=10e.g.C>10in-the-moneyat-the-moneyout-of-the-moneySource:Livingstone(1995) 274EconomicsforFinancialMarketsTable11.10ProfitsorLossesforBuyingaPutOption(E=$100)PriceofUnderlyingAssetatExpiration9698100104Buyput–3–3–3–3Buyunderlyingatexpiration–96–98Sellunderlyingintheopenmarket+100+100Netprofit=–Pp+E–P+1–1–3–3Source:Livingstone(1995)TheprofitprofileforaputoptionisshowninFigure11.7.Theputbuyermakesanetprofitifthepriceoftheunderlyingsecurityislessthantheexercisepriceminusthepurchasepriceoftheput(thatis,ifPECall00P–EPutE–P00Underlying+P+P+PLoan–E–E–ENet00P–ESource:Livingstone(1995)Table11.11showsthatthepurchaseofaEuropeancalloptionresultsinthesamecashflowsatexpirationaspur-chaseofaEuropeanputoptionplusthepurchaseoftheunderlyingassetplusborrowingthepresentvalueoftheexerciseprice.Positionswiththesamevalueatexpirationhavethesamevaluebeforeexpiration,assumingnointer-veningcashflows.Whatarethedeterminantsofthevalueofacalloption?Thevalueofacalloptionisdeterminedbythefollowingsixfactors.1.ThePriceoftheUnderlyingAsset.Thevalueofacalloptionispositivelyrelatedtothepriceoftheunderlyingsecurity.Thehigherthevalueofthe 276EconomicsforFinancialMarketsunderlyingasset,thegreaterthevalueofthecalloption.Thisisnotsurprising,asacallbuyerhasboughttherighttobuyatafixedprice.Themoretheunderlyingassetrisesthemorethecalloptionisworth,andviceversa.2.TheExercisePrice.Thevalueofacalloptionisinverselyrelatedtotheexerciseprice.Thelowertheexerciseprice,thehigherthevalueofthecalloption.Otherthingsbeingequal,alowerexercisepricemeansthatthecalloptionismorein-the-money.Againthisisnotsurprisingasthisiswhatthecalloptionownerhastopaywhenheorsheexercisestheoption.3.TheTimeuntilExpiration.Thevalueofacalloptionisapositivefunctionoftimeuntilexpiration.Thelongerthetimeuntilexpiration,thegreaterthevalueofthecalloption.Thereasonforthisisthatthecallownerhasmoretimetoallowhisorheroptiontogetin-the-money.Table11.12illustratesthefirstthreedeterminantsofcalloptionvalues.Lookacrossanyrowofthetable;thevalueofthecalloptiondecreasesastheexercisepriceincreases.Lookdownanycolumn;astimetomaturityincreasesandthevalueofthecalloptionalsoincreases.Table11.12TheImpactofMaturityandExercisePriceonCallOptionpricesMaturity(months)PriceofUnderlying=$110ExercisePrice$90$100$1103$30$16$46$34$19$6.509$37$21.50$8.50Source:Livingstone(1995)4.ThePriceVolatilityoftheUnderlyingAsset.Thegreaterthevolatilityoftheunderlyingasset,thehigherthevalueofthecalloption,sincepay-offstoacallbuyerareasymmetric.Iftheunderlyingassetdoespoorly,thecallbuyerloseseverything.Iftheunderlyingassetdoeswell,thecallbuyerdoesverywell.Greaterdispersioninthepossiblevalueoftheunderlyingassetimpliesbiggercalloptionpay-offsontheupsidebutthesamepay-off(lossofeverything)on Derivatives:whatdoyouneedtoknowaboutthem?277thedownside,makingacalloptionmorevaluable.Obviouslyassetpricescanfallaswellasrisebutiftheyfalltheoptionholderhastheoptionnottoexercisehisoption5.TheRisk-FreeInterestRate.Thehighertheinterestrate,thegreaterthevalueofacalloption.Thisisbasedonthefactthatifacallbuyerhasboughttheoptionratherthantheunderlyingassetthenthefundssavedcanbeinvestedatthenowhigherinterestrate.6.DividendsorInterestontheUnderlyingAsset.Thehigherthecashpaymentsontheunderlyingassetthelowerthevalueofacalloption.Thetotalreturnonanassetisthecashpayment(dividendsorcouponinterest)pluspriceappreciation.Foragiventotalrateofreturn,highercashpaymentsonanassetimplylowerreturnsfrompriceincreases.Sincethecallbuyergainsonlyifthepriceoftheunderlyingassetincreases,highercashpaymentsontheunderlyingassettendtoreducethecapitalgainsandthevalueofthecalloption.Fromput-callparity,thepriceofaputcanbeshowntodependuponthecallprice,thepriceoftheunderlyingasset,andthepresentvalueoftheexerciseprice.Itfollowsthattheprecedingsixdeterminantsofcallpricesalsoaffectputprices.Therearetwomajordifferencesforputoptions.First,asthepriceoftheunderlyingsecurityincreases,thevalueoftheputgoesdown.Thatis,thevalueofaputisinverselyrelatedtothepriceoftheunderlyingsecurity.Second,ahigherexercisepriceincreasesthevalueoftheput.Thevalueofaputoptionisdirectlyrelatedtotheexerciseprice.Table11.13providesanillustrationofhowbothcalloptionsandputoptionsrespondtothefactorsinfluencingtheirprice.Table11.13FactorsAffectingOptionPricesVariableincreasesCallpricePutpriceSharePriceIncreasesDecreasesTimetoExpiryIncreasesIncreasesShareVolatilityIncreasesIncreasesRiskFreeRateIncreasesDecreasesExercisePriceDecreasesIncreasesDividendDecreasesIncreases 278EconomicsforFinancialMarketsBlack–ScholesmodelThebinomialmodeldiscussedearlier,assumesadiscrete-timestationarybinomialstochasticprocessforsecuritypricemove-ments.Inthelimit,asthediscrete-timeperiodbecomesinfinitelysmall,thisstochasticprocessbecomesadiffusionprocess(alsocalledacontinuous-timerandomwalk,anItoprocess,orgeometricBrownianmotion).ThiswastheprocessassumedbyBlackandScholes(1973)intheirderivationoftheoptionpricingformula.Aswiththebinomialmodel,BlackandScholesbeginbyconstructingarisk-lesshedgeportfolio,longintheunderlyingsecurityandshortincalloptions.Thisportfoliogeneratestherisk-lessrateofreturn,buttheinternaldynamicsoftheportfolioaredrivenbythediffusionprocessforthesecurityprice.Thestructureofthehedgeportfoliocanbeputintoaformthatisidenticaltotheheatequationinphysics.Oncethiswasrecognized,thesolutiontotheequationwaseasilyderived.InthecaseofaEuropeancalloptionwithnocashpaymentsontheunderlyingassetandwithacertain,continuouslycompoundedinterestrate,BlackandScholesdemonstratedthatthevalueofacalloptionisanexplicitfunctionofthefirstfivefactorsmentionedabove.TheBlack–Scholesmodelisshowninequation(11.17).C=PN(d)–Ee–rtN(d)(11.17)12whereC=thepriceofacalloption,P=thecurrentpriceoftheunderlying,E=theexerciseprice,e=thebaseofnaturallogarithms,r=thecontinuouslycompoundedinterestrate,andt=theremaininglifeofthecalloption.N(d1)andN(d2)arethecumulativeprobabilitiesfromthenormaldistributionofgettingthevaluesd1andd2,whered1andd2areasfollows:1n(P/E)+(r+0.52)td1=σ√td2=d1–σ√twhereσ=thestandarddeviationofthecontinuouslycom-poundedrateofreturnontheunderlyingasset.Theterme–rtisthepresentvalueof$1receivedtperiodsfromthepresent.Itisthecontinuouslycompoundedequivalentofwhatwehavecalledd,thepresentvalueof$1. Derivatives:whatdoyouneedtoknowaboutthem?279N(d1)=0.75ProbabilityN(d2)=0.25d2Meand1ValuesofdFigure11.8Cumulativenormaldistribution.TounderstandtheBlack–Scholesmodelbetter,considerthecasewhereN(d1)andN(d2)arebothequalto1.Thisisequivalenttoassumingcompletecertainty.Thenthemodelbecomesequation(11.18).C=P–Ee–rt(11.18)N(d1)andN(d2)representcumulativeprobabilitiesfromtheNormaldistribution.Figure11.8illustratesthesecumulativeprobabilities,whichmustbenumbersbetween0and1.Iftheyarelessthan1.0,thereissomeuncertainlyaboutthelevelofthestockpriceatoptionexpiration.Fromthedefinitionofd1,d2mustbesmallerthand1.AssumethatweknowthatN(d1)is0.75andN(d2)is0.25.ThentheBlack–ScholesmodelbecomesCP–Ee-rtP–EtCallEPFigure11.9Black–Scholesmodel. 280EconomicsforFinancialMarketsequation(11.19).TheBlack–ScholesfunctionisshowninFigure11.9.C=(0.75)P–(0.25)Ee–rt(11.19)SincetheBlack–Scholesmodelrequiresnocashpaymentsandinterestratecertainty,itcannotbeappliedtodebtinstruments.However,theBlack–Scholesmodelscanbeappliedtocommonstockswithoutdividends.Themodelcanbeadaptedforcommonstocksthatpaydividends.OneoftheattractionsoftheBlack–Scholesmodelisthatmostoftheinputsarereadilyobservable.Thestandarddeviationofthereturnontheunderlyingassetisnotdirectlyobservable.However,thiscanbeestimatedfrompastdata,ifthestandarddeviationisrelativelystableovertime. 12Theneweconomicparadigm:howdoesitaffectthevaluationoffinancialmarkets?Duringthe1990s,strongeconomicgrowthintheUnitedStates,combinedwithlowinflationandapick-upinlabourproductiv-itygrowth,ledmanypeopletolabelthephenomenona‘neweconomy’.ButthereisreallylittleconsensusonwhatisdifferentabouttheUSeconomynoronwhatthetermmeans.Inthischapterweexaminethecomponentsthatwouldbeincludedinageneraldiscussionoftheneweconomy.TheneweconomydefinedDefinitionsofthe‘neweconomy’arenotprecisebuttypicallyincludeoneormoreofthefollowingcharacteristics.1.AhigherrateofproductivitygrowthThehigherrateofproductivitygrowthislargelyrelatedtoinvestmentininformationtechnology(IT).Thishasresultedinwhateconomistsrefertoas‘capitaldeepening’,theprocesswherebythequantityofcapitalperworkerincreasesovertime(thecapital/labourratio).Recentexamplesofthisaretheinvestmentininformationtechnologiesreflectingfallingcom-puterpricesandnewwayscomputerscanhelpaccomplisholdtaskswithfewerinputs.Themicroprocessorliesattheheartofthesetechnologicaldevelopments.Themicroprocessor’sability 282EconomicsforFinancialMarketstomanipulate,storeandmovevastamountsofinformationhas,itisargued,shiftedtheUSeconomy’scentreofgravity,creatingtheeraofsmaller,faster,smarter,better,cheaper.Togainanappreciationoftheimplicationsofthesetechnologicaldevelopmentsitisinstructivetolookbackinhistory(seeMcTeer,1999).From1895to1915,agreatburstofinventivenessusheredinaneraofrapidtechnologicalchangeandeconomicgrowth.Americanssawthearrivalofonemarvelafteranother–automobiles,aeroplanes,telephones,phonographs,radios,elevators,refrigeration,andmuchmore.ThesenewinventionsbarelyregisteredasablipinaGDPdominatedbyfarming,shopkeepingandsmall-scaleproduction.Intime,though,theindustriesthatgrewoutofthemformedtheeconomicbackboneofthe20thcentury.Theadvancesofthislong-agoerawouldhavebeenimpossiblewithoutatechnologythatarrivedjustaftertheCivilWar:electricity.ThomasEdisoncreatedthelightbulbin1879forthesimpletaskofilluminatingaroom.Tobuildamarketforhisinvention,Edisonharnessedelectricity,buildingtheworld’sfirstgeneratingplantandadistributionnetworkinNewYorkCity.Asitspreadthroughtheeconomy,electricityrecasttheeconomicparadigm.Withoutelectricity,therewouldbenosparkforinternalcombustionengines,nopowerfortelephones,radios,refrigeratorsandairconditioners.Electricityprovidedanever-readyenergysourceforfactories,withmassproductiondrivingdownthecostofmakingjustabouteverything.Likeelectricity,themicroprocesorisanimportantinventioninitsownrightandonethatshooktheworldasittouchedoffarapid-fireproliferationofspillovers.In1958JackKilbyofTexasInstrumentsfashionedthefirstintegratedcircuit,abundleoftransistorsonapieceofsilicon.Thusbeganthegrandthemeofmodernelectronics–eversmaller,evermorepowerful.Thirteenyearslater,TedHoffofInteldevelopedthesilicon-etchingprocessthatproducedthefirsttruemicroprocessors.Initialapplicationscentredonnumbercrunchingandrapiddataentry.Handheldcalculatorsarrivedin1972,barcodescannersin1974andthepersonalcomputerin1975.Overthenextdecadeorso,Americanindustryappliedmicroprocessorstoothertasks.Wholenewproducts,progenyofthedigitalelectronicrevolution,burstontothemarketplace,e.g.cellulartelephones,roboticfactoryhands,airtrafficcontrolsystems,globalpositioningsatellites,lasersurgerytools,cam-corders,palm-sizepersonalorganizers,tonameafew. Theneweconomicparadigm:howdoesitaffectthevaluationoffinancialmarkets?283Microprocessorsmadeexistingproductsbetter,cheaperandmoreefficient.Startingintheearly1980s,‘smart’featureshelpedfine-tunetelevisions,cutenergyusebyrefrigerators,controlcookinginmicrowaveovens,memorizeprogrammeschedulesinVCRsandgeneratediagnosticreportsforautomobiles.Universitieswerethefirsttohookcomputersintonetworks,butitwasn’tlongbeforeeverydayAmericansbegantoconnectviaelectronicmail.TheInternetenteredthe1990sasanobscurecommunicationsnetworkforeducatorsandscientists.Itendedthedecadeasthelibrary,shoppingmallandplay-groundofthemasses.TheInternetiscreatingspilloversmakingexistingindustriesmoreefficientandspawningentirelynewones,includingwebpagedesignandInternetservice.Computerprocessingpowerleapt7000foldinthreedecades.Numbercrunchingtasksthattookaweekintheearly1970snowrequirebutaminute.ThePentiumchip,releasedbyIntelinMay1993,crowds3.1millionflawlesstransistorsonasquareofsilicon16by17mm.Itcanchurnoutcalculationsatupto112millioninstructionspersecond(mips).Datastoragecapacityandtransmissionspeedssurgedrightalongwiththemorepowerfulmicroprocessors.Asinglememorychipnowholds250000timesasmuchdataasonefromtheearly1970s–thedifferencebetweenonepageoftextand1600books.Transmissionspeedsincreasedbyafactorofnearly200000.Sendingthe32-volumeEncyclopaediaBritannicaonthethenequivalenttotheInternetfromNewYorktoSanFranciscowouldhavetaken97minutesin1970.Today’strunklinescanmovetheequivalentofeightfullsetsinjustonesecond.Greatleapsofpower,capacityandspeedledtoevengreaterreductionsinthecostofmanaginginformation.Intel’svintage1970chipssoldfor$7600permegahertz.Today’sPentiumIIIchipsuppliesitscomputingpowerfor17¢permegahertz.Thecostofstoringonemegabitofinformation,enoughfora320-pagebook,fellfrom$5257in1975to17¢in1999.SendingtheEncyclopaediaBritannicacoasttocoastwouldhavecost$187in1970,largelybecauseofslowdata-transmissionspeedsandtheexpenseofalong-distancetelephonecall.Today,theentireLibraryofCongresscouldmoveacrossthenationonfibre-opticnetworksforjust$40.Asthenewtechnologybecamebetterandcheaper,Americanbusinessesandhouseholdsembracedit.OnlyafewthousandhomeshadaPCin1980.NowmorethanhalfofUSfamiliesowncomputers,thenewestofthem200timesmorepowerfulthan 284EconomicsforFinancialMarketsIBM’sfirstPC,introducedin1981.Three-fifthsofUShouse-holdsareconnectedtotheInternet,amodeofinstantcommu-nicationscarcelyheardofevenatthestartofthe1990s.Thisgrowthintechnologyprovidestheunderpinningtotheideathattheoldrulesofeconomicshavebeendramaticallychanged.2.AriseintotalfactorproductivitygrowthTotalfactorproductivitygrowthreferstothegrowthinoutputthatisnotexplainedbythephysicalincreaseineithercapitalorlabour.Itscontributiontoeconomicgrowthisnoteasytoidentifyandmeasurebutneverthelessitisanimportantsourceofeconomicgrowth.Thisphenomenonisduetotheincreasedutilizationofinformationtechnologyacrosstheeconomyresultinginspillovereffects.Totalfactorproductivitygrowthdependson:technologicalchangeotheradvancesinknowledge,e.g.just-in-timemanufacturingeconomiesofscale.Spillovereffectsoccurwhenreturnstoaninvestmentincreasebecauseothersmakesimilarinvestments.ExamplesherewouldbenetworkingandthereturnstoanInternetcapablecomputerasmoreconsumersandbusinessesconnecttotheInternet.TheeffectoftheInternethasbeentointensifyproductmarketcompetitionwithassociatedefficiency.ThepotentialimpactoftheInternetgainscanbeseenfromFigure12.1.Ittook36yearstoachieve50millionusersforradio,13yearsforTV,16yearsforPCsbutfortheInternetithastakenfewerthanfiveyears.Technologyspillovers:increasingreturnsanddecreasingcostsEvenwhenindividualindustriesfacedecreasingreturnstoscale,theeconomyasawholemayenjoyincreasingreturnswhentechnologyspilloversfromoneindustrybenefitothers.Technologyspilloversareespeciallyabundantwithinventions,whoseapplicationsspreadfarandwide.Innovationinonecompany,althoughintendedsolelyforinternalbenefit,cansparkinnovationinothers,triggeringapowerful,economy-widecascadingeffect.Revolutionarytechnologiescantakedecadestospawnalltheirspillovers,duringwhich,forallpracticalpurposes,aggregatereturnstoscaleincrease.Exam-plesofthiswouldincludethefollowing. Theneweconomicparadigm:howdoesitaffectthevaluationoffinancialmarkets?285TexasInstrumentswastryingtoreducethesizeofelectroniccircuitrywhenengineerJackKilbydevelopedtheintegratedcircuitin1958.ThebenefitsofthatinnovationfarexceededwhatTexasInstrumentscouldinternalize,openingawholenewscienceinwhichelectroniccircuitrywouldshrinktosizesoncethoughtunachievable.IntelwaspursuingcircuitrysmallenoughforapocketcalculatorwhenTedHoffdevelopedthesilicon-etchingprocessthatultimatelyledtothemicroprocessor.A1971advertisementinElectronicNewsheraldedthe‘computeronachip’andsignalledthestartofthedigitalage.Inseekingtomakemicroprocessorseversmaller,IBMdevelopedthescanningtunnellingmicroscope.Thebenefitsofthatresearch,however,wentfarbeyondwhatwasenvi-sioned.Themicroscopeenabledanentirelynewindustry,i.e.,nano-technology,thatpromisestodelivermolecularly-engineeredmaterialsthatwillreshapeourworld.Gordon(1998a),aleadingneweconomysceptic,arguesthatcomputerspaleincomparisontoearliertechnologicaladvances,suchaselectricity,theinternalcombustionengine,orbio-technology.Healsoarguesthatcomputersmaynotbeexceptionallyproductivesincetheyprimarilyredistributeout-put,notcreateit.BythisGordonmeansthatcomputersmayincreasetheutilityofworkersbyprovidingbetterworkingconditions,whichwouldincludecomputergames,ortheycreateoutputwhichisunvaluedbycustomers,e.g.fancyfonts.40353025yearsf20No.o151050BroadcastBroadcastPersonalCommercialradiotelevisioncomputersInternetFigure12.1Yearstoachieve50millionusers.(Source:USCommerceDepartment.) 286EconomicsforFinancialMarkets3.AnincreaseinfactorutilizationThisisseenmostclearlyinthedeclineintheNon-AcceleratingInflationRateofUnemployment(NAIRU),aconceptfirstdefinedbyModiglianiandPapademos(1975).Manyeconomists(e.g.Meyer,1997)subscribetotheviewthatthereissomethresholdleveloftheunemploymentrateatwhichsupplyanddemandarebalancedinthelabourmarket(andperhapsintheproductmarketaswell).Thisbalanceyieldsaconstantinflationrate.SoNAIRUisthatrateofunemploymentwhichcanbesustainedwithoutachangeintheinflationrate.Iftheunemploymentratefallsbelowthisthresholdlevel(NAIRU),inflationtendstoriseprogressivelyovertime.TheUSunemploymentratethroughoutthelate1990sandearly2000swaswidelybelievedtobebelowthisthreshold;hencethepuzzlementatthelowinflationrate.ApossibleexplanationoftherecentfailureofinflationtoriseinthefaceofstrongGDPgrowthandlowunemploymentisthattheNAIRUhasdeclined,i.e.,theleveloftheunemploymentrateatwhichthesupplyofanddemandforlabourareinbalancemaybelowerthanitusedtobe.Theargument,expressed,forexample,byFederalReserveChairmanAlanGreenspan(1997),thattechnologicalchangehasaddedtoworkers’insecurityinrecentyearsandmadethemlesswillingtopushforhigherwages,maybethoughtofasoneversionofthisexplanation.Greaterinsecuritymightreducetheupwardpressureonwageratesatanyunemploymentrateandsolowerthethresholdrateatwhichwages(andprices)wouldbegintomoveupward.ThereasonwhyintensificationofproductmarketcompetitionshouldlowerthelevelofNAIRUisduetotheeffectoftheInternetandtotheglobalizationofworldmarkets(discussedbelow).Wadhwani(2000)hasdemonstratedthattheeffectoftheInternetintheretailmarketshouldbetolowerprices.Thisisbecause:lowersearchcostsshouldleadtolowerpriceslowermarketentrycostswilllimitthepricepremiumssustainablebyexistingmarketparticipants,byincreasingactualorpotentialcompetitionshorteningthesupplychainwilllowerdistributionandinventorycost.EstimatesofNAIRUsuggestthatthelowlevelofunemploymentduringthelate1990sandearly2000sshouldhaveproducedafairlysignificantaccelerationinprices,yetinflationcontinuedtodecline.SomelikeRobertGordon(1997)andStaiger,Stock, Theneweconomicparadigm:howdoesitaffectthevaluationoffinancialmarkets?287andWatson(1997),tookthisoccurrenceasevidencethattheNAIRUhasdeclined.Othersarguedthatspecialfactors,suchasrecentmovementsofemployeehealthcoveragetohealthmaintenanceorganizations,hadtemporarilymaskedtheincreaseininflation.Anotheroftencitedexplanationforthesurprisinglygoodinflationperformanceofthelate1990sconcernstheincreasingsensitivityoftheUSeconomytoforeigneconomicconditions.SincecapacityutilizationoutsidetheUShasbeenslackinrecentyears,itisargued,USinflationhasremainedmild.Thereasoningbehindthisliesintheglobal-izationoftheworldeconomy,discussedbelow.4.Globalizationoftheworldeconomy‘Globalization’initseconomicaspectreferstotheincreasingintegrationofeconomiesaroundtheworld,particularlythroughtradeandfinancialflows.Thetermsometimesalsoreferstothemovementofpeople(labour)andknowledge(technology)acrossinternationalborders.Increasingandunprecedentedglobalization,drivenpartlybytechnologicalchangeandpartlybythedeliberateremovalofgovernment-createdbarrierstotheinternationalmovementofgoods,services,people,financialcapital,enterprisesandideashastransformedtheinternationalanddomesticcompetitiveenvironments.Atitsmostbasic,thereisnothingmysteriousaboutglobal-ization.Thetermhascomeintocommonusagesincethe1980s,reflectingtechnologicaladvancesthathavemadeiteasierandquickertocompleteinternationaltransactions,bothtradeandfinancialflows.Itreferstoanextensionbeyondnationalbordersofthesamemarketforcesthathaveoperatedforcenturiesatalllevelsofhumaneconomicactivity,e.g.villagemarkets,urbanindustries,orfinancialcentres.Marketspromoteefficiencythroughcompetitionandthedivisionoflabour–thespecializationthatallowspeopleandeconomiestofocusonwhattheydobest.Globalmarketsoffergreateropportunityforpeopletotapintomoreandlargermarketsaroundtheworld.Itmeansthattheycanhaveaccesstomorecapitalflows,technology,cheaperimports,andlargerexportmarkets.Criticsoftheviewthatglobalizationcanraiseproductivityandcontaininflation,particularlyKrugman(1997),pointoutthatabout85percentoftheUSeconomy,primarilyservices,isnotsubjecttotheintensepressureofthemarketplace. 288EconomicsforFinancialMarketsSowhatistheneweconomicparadigm?TheneweconomicparadigmmaybesummarizedastheviewthatglobalizationandinformationtechnologyhasledtoasurgeintheproductivityofUSworkers.This,inturn,hasproducedasharpincreaseintherateofgrowththattheUSeconomycanachievewithoutrunningupagainstinflationarycapacitylimits.AttheheartoftheneweconomicparadigmisthebeliefthattheUSeconomyisinaphaseofstructural,ratherthancyclical,improvement.Theessenceofthenewparadigm(andofitsfollowers,thenewparadigmatics,astheproponentsofthisideaareknown)istheclaimthatthechangeseveryonecanseeintheUSeconomy–theriseofdigitaltechnology,thegrowingvolumeofinternationaltradeandinvestment–havequalitativelyalteredtheeconomicrulesasrepresentedbystandardeconomictheories.Rapidtechnologicalchangemeansthattheeconomycangrowmuchfasterthanitusedto.OneimplicationbeingputforwardbythenewparadigmaticsisthattheUSFederalReserveshouldadopthighereconomicgrowthtargetsinitsmonetarytargeting.Thereisnodoubtthattherehasbeenarevolutionininformationtechnology.Itisallaroundus,e.g.faxmachines,WAPcellularphones,personalcomputers,modems,theInter-net,tonamejustasmallsampleofthechangestakingplace.Thechangestakingplaceareinfactdeeperthanacursoryexaminationwouldindicate.Informationhasnowbeendigitized–words,pictures,dataandsoon.Digitizationreferstoaprocesswherebyinformationisprocessedbymanipulatingnumericaldigits.Thealternativewayofprocessinginformation,analog,reliesonvisualinforma-tion,e.g.thefiguresonaclock.Thecrudestdatarepresentationisbinary:everyfacttoberepresentedmustbedistilledtoayesorano,a1ora0.Thecorrespondingmeasureisthebinaryinformationunit,orbit.Ayesoranoisabit.Amixtureof20yessesandnoesrepresents20bits,whichactuallyallowsoveramillioncombinations.Digitalinformationtechnologyusuallyworksinternallywithtwovoltagelevels,representing0and1respectively.Digitizationenablesinformationtobegivenaquantitativedimension.Thisdigitaltechnologyiscreatingnewcompaniesandnewindustries. Theneweconomicparadigm:howdoesitaffectthevaluationoffinancialmarkets?289HousingandcarsusedtodrivetheUSeconomy.Nowinformationtechnologyaccountsforaquartertoathirdofeconomicgrowth.Informationtechnologyaffectseveryotherindustry.Itboostsproductivity,reducescosts,cutsinventories,andfacilitateselectroniccommerce.Itis,inshort,atranscend-enttechnology,likerailroadsinthenineteenthcenturyandautomobilesinthetwentieth.Thenewparadigmaticsarguethatproductivitygrowthhasaccelerated,whichmeansthattheacceptablerateofeconomicgrowthtakingplacewithoutinflationarypressuresbuildingup,hasbeenrepealed.Herethestatisticsareclear.AnnuallabourproductivitygrowthfortheUSnon-farmbusinesssectoraveraged2.8percentoverthe1995–2000period,doubleitsaverageannualrateofgrowthfor1973–95andjustshortofits2.9averagefor1959–73.AsRobertSolow(1987),NobelPrizewinnerforEconomics,famouslycommented‘Thecomputeriseverywhereexceptintheproductivitystatistics’,acommentwhichisnowseentobepremature.Asecondthemeofthenewparadigmaticsisthatglobalcompetitionhastheeffectthattheeconomydoesnotneedtofearoverheatingandthesubsequentinflation.Theimplicationbeingpropoundedhereisthatbecauseofglobalizationmonetaryexpansioncannowbepursuedwithouttheriskofinflation.Theglobalizationofbusinessreferstothefactthatcapitalismisspreadingaroundtheworld.Thismaynotbefull-blowncapitalismbutatleastweareseeingthewidespreadintroduc-tionofmarketforces,freertradeandwidespreadderegulation.Itishappeningintheformercommunistcountries,inthedevelopingworldofLatinAmerica,andAsia.Thesetwotrends,informationtechnologyandglobalization,areunderminingtheoldorder,forcingbusinesstorestructure.Ifyouwanttocompeteinglobalmarketsortakeadvantageofrapidtechnologicalchange,sotheargumentgoes,youhavetomovequickly,andthatoftenmeansgettingridoflayersoftechnology.Theeffectisaradicalrestructuringthatmakesbusinessmoreefficient.Critics,particularlyKrugman(1997),contendthatthereareconceptualandempiricalholesinthenewparadigmwhichmeanthatwehavenotenteredanewworldofhighereconomicgrowthwithouttheundesirableeffectsofinflation.Movingontothenextaspectofthenewparadigmthinking,theargumentclaimsthatthehappycombinationoflowunemploymentandlowinflationprovesthepay-offfromhigher 290EconomicsforFinancialMarketsproductivitygrowth.Thereisnodoubtthathigherproductivitygrowthdoesmeanlowerinflationforanygivenrateofwageincrease.Turningnowtothenewimportanceofglobalcompetition.Unlikeinthepast,thestorygoes,UScompaniesnowhavetofaceactualorpotentialcompetitionfromrivalsinEuropeandAsia;thuseveninthefaceofstrongdemandtheywillnotdareraiseprices,forfearthattheserivalswillseizethemarket.Itispossibletoquestionthisassertiononthefacts.TherearewithoutquestionmanyAmericanfirmsfacinginterna-tionalcompetitiontoanunprecedenteddegree.However,suchglobalcompetitionmainlyoccursinthegoods-producingsec-tor(veryfewservicesaretradedoninternationalmarkets)andevenwithinmanufacturingtherearemanyindustriesthatremainlargelyisolatedfromforeigncompetitors(asKrugmancomments,‘seenanyChineserefrigeratorslately?’).SincetheUSismainlyaserviceeconomy,thismeansthatnomorethan25percentandprobablylessthan15percentofemploymentandvalue-addedareactuallysubjectedtothekindofglobalmarketdisciplinethatthenewparadigmemphasizes.Whyhasthepost-1991USeconomicexpansionnotresultedinrisinginflation?AnovelmethodforunderstandingtherecentbehaviourofUSinflationhasbeenpropoundedbyRichandRissmiller(2000)andthishasattractedtheattentionoffinancialmarketanalysts.ThelongevityoftherecentUSbusinesscycleexpan-sionaryphasehasnotresultedinthestandardtextbookeffectofrisinginflation.Twomajorexplanationshavebeenofferedforthis.Thefirstattributesthelowratestoconventionaleconomicforcesand,inparticular,toaseriesof‘positivesupplyshocks’.Theseshocksincludeperiodicdeclinesincommodityandenergyprices,intervalsofdollarappreciation,anddramaticallyslowergrowthinmedicalcosts.Suchshocksaretransitoryinnatureandsocanbereversedatanytime.Thesecondexplanationforthebehaviourofinflationduringthelastdecadeholdsthatheightenedcompetitionamongproducersandtheproductivityadvancesmadepossiblebythenewinformationtechnology,havefundamentallyalteredtherelationshipbetweeneconomicgrowthandinflation.Accord-ingtothisexplanation,thelowinflationratesreflectapermanentchangeinthedynamicsoftheinflationprocess. Theneweconomicparadigm:howdoesitaffectthevaluationoffinancialmarkets?291ThetrianglemodelTounderstandthebehaviourofinflationduringthecurrentexpansion,RichandRissmilleruseaformulationofthePhilipscurveknownasthetrianglemodelofinflation(seeFigure12.2).DevelopedprincipallybyRobertGordonofNorthWesternUniversity,thetrianglemodeltakesitsnamefromthespecifieddependenceoftheinflationrateonasetofthreedeterminants:inertia,demand,andsupply.Howdothesedeterminantsaffectinflation?InertiaInertiadescribesthetendencyofinflationtodeviateonlygraduallyfromitsownpastvalues.Whentheeconomyisbuffetedbyashock,inflationrespondsslowly,withchangesoccurringoveranumberofquartersoryears.Variousexplana-tionsforthepersistenceofinflationhavebeenproposed.Someeconomistsarguethatthesluggishadjustmentofinflationexpectationskeeptherateofincreaseinthegeneralpricelevelonasteadycourse.Otherscontendthatthepresenceofwageandpricecontractsintheeconomyactsasasignificantrestraintonrapidchangesininflation.Butwhateveritssources,thisslowadjustmentmeansthatpastinflationwillhelptodeterminethecurrentlevelofinflation.DemandUnderstandinghowdemandaffectsinflationisabitmorecomplicated.TherelationshiprequiressomefamiliaritywithInertiaSupplyDemandFigure12.2Thetrianglemodelofinflation. 292EconomicsforFinancialMarketsthenotionofoutputtrends.Theamountofoutputproducedintheeconomytendstogrowovertimebecauseofincreasesinlabourandcapitalandadvancesintechnology.Althoughtheutilizationoftheseresourcesvariesoverthebusinesscycle,theirlong-runmovementscanbethoughtofasgenerat-ingasmoothunderlyingtrendforoutput.Whendemandisabovethetrendlevelofoutput,thereisexcessdemandintheeconomyandinflationwillbegintorise.Whendemandisbelowthetrendlevelofoutput,thereisslackintheeconomyandinflationwillbegintofall.Economistsassumethatthereareuniquelevelsofunemploymentandcapacityutilizationthatcorrespondtothistrendgrowthinoutput.Togaugeexcessdemandpressuresintheeconomy,economistscon-structproxiesmeasuringthecurrentdeviationofademandvariable,suchasunemploymentorcapacityutilizationfromthelevelatwhichtherewouldbenotendencyforinflationtoaccelerateordecelerate.SupplySupplyfactors,thethirddeterminantinthetrianglemodel,influenceinflationthroughsharpchangesinbusinesscosts.Inthe1970s,largeincreasesinthepriceofimportedinputsraisedproducers’costsdramaticallyandcontributedtoaccelerationininflation.SuchsupplyshocksmaytakeongreaterrelevanceastheincreasedopennessoftheUSeconomyexposesdomesticproducersandconsumersmorefullytoshiftsinthepricesofimportedinputsandfinalgoods.Variablesintendedtocapturesupplyshocksincludethepriceofimportsaswellasfoodandenergyprices.Allthreeoftheseitemscanaffectinflationdirectlybecausetheyarecomponentsofthedomesticpriceindex.Inaddition,importpricesmayhaveanindirecteffectoninflationbecausechangesinimportpricescaninducedomesticfirmstoalterthepricesofcompetinggoods.Doesthemodelwork?RichandRissmillerfoundthatconventionaleconomicforces,particularlythedeclineinimportpricesexplainedalargeproportionofthedeclineininflation.Supplyshocksandotherconventionaleconomicfactors,ratherthanachangeintheinflationprocessitself,underlinethelowratesofinflationofthe1990s. Theneweconomicparadigm:howdoesitaffectthevaluationoffinancialmarkets?293ThenewparadigmandthepriceearningsratioThechangingstructureoftheUSeconomy,itcanbeargued,hasradicallyalteredthebusinessenvironmentinamannernotyetfullyaccountedforbyaccountingconventions.Newlydevelopedproducts,widelyused,havenecessitatedlarge-scaleinvestmentinwhataccountantscallintangibleassets,raisingthevalueofcopyrightsandpatents.Microsoft’sWindows98,Paramount’smovie‘Titanic’,Pfizer’sViagra,andGillette’sMach3razorbladesarefourprominentexamplesofthis.Developingeachproductrequireditscorpo-ratesponsortoinvesthundredsofmillionsofdollars.Forexample,Gilletteinvested$700milliontodeveloptheMach3razorbladeinaneffortbegunin1990.Paramountspentover$200milliontobringdirectorJamesCameron’svisionof‘Titanic’tothescreen.Theseinvestmentexpendituresgaverisetoeconomicallyvaluable,legallyrecognizedintangibleassets,includingcopy-rights(‘Titanic’andWindows98)andpatents(ViagraandMach3)thatgivetheinvestingfirmstheexclusiverightforacertainperiodtosellthenewlydevelopedproducts.Pfizersoldover$700millionworthofViagrain1998afteritsintroductioninAprilofthatyear;‘Titanic’sold$1billionincinematicketsbeforeitenteredvideosales;andGillette’sMach3razorbladewasthetopsellerintheUSbytheendof1998,havingsecuredmorethan10percentoftherazorbladereplacementmarketinlessthanafullyear.Patentsandcopyrightsonnewconsumerproductsarenottheonlytypesofintangibleassets.Newprocessesformakingexistinggoods,suchastheprocessforcoatingcookiewaferswithchocolate,andnewproducergoods,suchasPCserversandfibre-optictelephonecables,canalsobepatentedorcopyrightedor,perhaps,protectedastradesecrets.Otherintangibleassetsarebrandnamesandtrademarks,whichcanhelpafirmtocertifythequalityofanexistingproductorintroducenewproductstopotentialpurchasers.Notonlycanareputationforqualitypersuadeshopperstotryanitemforthefirsttime,butacleveruseofadvertisementscangoalongwaytowardtargetingpreciselythosewhowillgainthemostfromtheproductandthereafterbecomeloyal,repeatcustomers. 294EconomicsforFinancialMarketsYet,becausetheyarenotinvestmentsintangibleassets,mostexpendituresonintangibleassetsarenotfullyrecognizedasinvestmentsineitherUScompanies’financialaccountsortheUSnationalincomeandproductaccounts.ThispracticemayhavebeenreasonablewheninvestmentinsuchassetswasanegligibleportionofUStotalinvestment,butthatisnolongerthecase.Theeffectofthislackofrecognitionisthatcorporateprofitsareunderstatedbecausecorporationsareinvestingmoreoftheircashflowinintangibleassets.Asaresultprice/earningsratiosareoverstated,makingcomparisonbetweendifferingtimeperiodsanddifferentcompaniesdifficulttouseasbasesfordecidingwhethermarketsorindividualcompaniesareovervaluedorundervalued.Otherthingsbeingequal,theprice/earningsratioshouldbehighwhentheexpectedgrowthrateofprofits(andthusofearningspershare)ishighrelativetotherateofreturnthatstockholdersrequireonthesharestheyown.Thatcanhappenwhenprofitsaretemporarilylowandexpectedtobounceback,aswasthecaseduringthe1990–91recessionintheUnitedStates.Itcanalsohappenwhenprofitsarehigh,asduringthesecondhalfofthe1990s,iftheyareexpectedtogrowrapidlyinthefuture.Butinthelongrun,profitshavetendedtogrowatthesamerateastheeconomyasawhole.Itisthereforelegitimatetoaskifthereisanyrationalreasontobelievethatprofitsshouldgrowstronglyinthefutureandtherebyjustifythe,untilrecently,highvaluationsplacedonstocks.Infact,asNakamura(1999)hasshown,thereis.AsNakamurashows,risinginvestmentinintangibleassetsreducesmeasuredcurrentprofitsandraisesexpectedfutureprofits.Thus,risingnewproductdevelopmentcanhelptoexplainthecurrenthighprice/earningsratio.Theaccuratemeasurementofprofitsisfundamentaltofinancialaccounting.Profittellsustwothings:howmuchrevenueexceededcosts(ameasureoftheeconomicvalueofcurrentoperationsofthefirm),andhowmuchtheassetsofthecorporationhaveincreased(beforeanycashdistributionstoshareholders).Accountantsformallydefineprofitas‘Theexcessofrevenuesoverallexpenses’.Expensesare‘thecostsofgoods,services,andfacilitiesusedintheproductionofcurrentrevenue’(Estes,1981).Totheextentthatafirmbuysthingsthatarenotusedupinproduction,thoseadditionalcostsareinvestments,notexpenses,andarecapitalized,i.e.,consideredasassets.Acapitalassetgivesrisetoanexpenseonlytothe Theneweconomicparadigm:howdoesitaffectthevaluationoffinancialmarkets?295extentthatthecapitalasset’svaluefallswhileinuse,aprocesscalleddepreciationorcapitalconsumption.ResearchandDevelopmentcostsaretreatedaspartofthecurrentexpensesofthefirm,andthistreatmentreducesreportedprofits.IfR&Dexpenditurewastreatedasinvest-mentandcapitalizedanddepreciatedaccordingly,theprofit-abilityofUSnon-financialcorporationswouldhavebeenmuchhigher.ThusthehighP/Eratiosofthe1990sbecomeeasiertounderstand. 13Bubbleologyandfinancialmarkets‘Howdoweknowwhenirrationalexuberancehasundulyescalatedassetvalues?’(AlanGreenspan,1996)IntroductionTheabovequotebyAlanGreenspan,ChairmanoftheUSFederalReserve,provokedalargefallintheUSstockmarketandopenedupthedebateastowhetherornotstockmarketsarepronetospeculativebubblesand,ifso,astohowfinancialeconomistscanidentifythem?Movementsinpricesinanymarketwhicharethoughttobeself-fulfillingpropheciesareoftencalled‘bubbles’todenotetheirdependenceoneventsthatcomefromoutsidethemarketbeingstudied.Proponentsoftheideathatbubblesinfinancialmarketsoccurareusuallyreferredtoas‘bubbleologists’.TheideathatbubblesexistisoftentracedtoJohnMaynardKeynes.‘Professionalinvestmentmaybelikenedtothosenewspapercompeti-tionsinwhichthecompetitorshavetopickoutthesixprettiestfacesfromahundredphotographs,theprizebeingawardedtothecompetitorwhosechoicemostnearlycorrespondstotheaveragepreferencesofthecompetitorsasawhole;sothateachcompetitorhastopick,notthosefaceswhichhehimselffindsprettiest,butthosewhichhethinkslikeliesttocatchthefancyofothercompetitors,allofwhomarelookingattheproblemfromthesamepointofview.Itisnotacaseofchoosingthosewhich,tothebestofone’sjudgement,arereallytheprettiest,noreventhosewhichaverageopiniongenuinelythinkstheprettiest.Wehavereachedthethirddegreewherewedevoteourintelligencestoanticipatingwhataverageopinionexpectstheaverageopiniontobe.Andtherearesome,Ibelieve,whopracticethefourth,fifthandhigherdegrees.’(Keynes,1936) Bubbleologyandfinancialmarkets297ThestockmarketKeynes(1936)wrote,‘isagameofmusicalchairs,ofSnap,wherethewinneristheonewhomakeshismovefractionallyaheadofeveryoneelse’.Sotheequitymarket,inKeynes’sview,isanenvironmentinwhichspeculatorsanticipate‘whataverageopinionexpectsaverageopiniontobe’,ratherthanfocusingonfactorsfundamentaltothemarketitself,includingexpectedfuturedividendsetc.Theimplicationhereisthatifbubblesexistinassetmarketspriceswilldifferfromtheirlong-termfundamentalvalues.Itisonlyrecentlythatseriousresearchhastakenplaceontheexistenceofbubbles.Economictheory,untilrecently,placedessentiallynorestrictionsonhowagentsformedexpectationsoffutureprices.Thusafolkloreofbubblesgrewup.ThesewouldincludethetulipbubblesinseventeenthcenturyHolland,theSouthSeabubbleineighteenthcenturyEngland,andtheincreaseinequitypricesduringthe1920sintheUnitedStates.Alltheseevents,whenfollowedbysubsequentcollapsesinassetvalueshavebeenlabelledasbubbles.However,thewidespreadadoptionofrationalexpectations,discussedbelow,providesamodelamenabletotheempiricalstudyofbubbles.Butfirstofallweneedtodescribetheterminologyusedby‘bubbleologists’.ThebubbleterminologyFollowingthetechnicallanguageofeconomics,a‘bubble’isanydeviationfrom‘fundamentalvalues’whetherupordown.Fundamentalvaluesareaconcepteasiertodefineintheorythaninpractice.Thisreferstothepricesstocksoughttosellforbasedonbusiness’srealeconomicvalue,speculationapart.Theassumptionisthatstockpriceswillultimately(wheneverthatis)returntotheirfundamentalvalues,howevermuchextraneousfactorsmaybeinfluencingthematanyonemoment.Abubbleisanupwardpricemovementoveranextendedrangethatthenimplodes.Anextendednegativebubbleisacrash.‘Noise’referstosmallpricevariationsaboutfundamentalvalues.Soabubbleisasituationinwhichthepriceofanassetdiffersfromitsfundamentalmarketvalue.Witharationalbubble,asdiscussedbelow,investorscanhaverationalexpec-tationsthatabubbleisoccurringbecausetheassetpriceisaboveitsfundamentalvaluebutcontinuetoholdtheassetanyway.Theymightdothisbecausetheybelievethatsomeone 298EconomicsforFinancialMarketselsewillbuytheassetforahigherpriceinthefuture.Inarationalbubble,assetpricescanthereforedeviatefromtheirfundamentalvalueforalongtimebecausetheburstingofthebubblecannotbepredictedandsotherearenounexploitedprofitopportunities.TheroleofexpectationsinanalysingbubblesBeliefsaboutthefutureareanimportantdeterminantofbehaviourtoday.Importantdisagreementsbetweendifferingviewsofhowexpectationsareformedlieatthecentreofthediscussionastotheexistenceorotherwiseofbubbles.Differentviewsaboutexpectationscanbeusefullybrokendownintothreegroups:exogenousexpectations,extrapolativeexpecta-tions,andrationalexpectations.Wewilldiscussthesethreegroupsinturn.ExogenousexpectationsSomeeconomistsremainalmostcompletelyagnosticonthevitalquestionofhowexpectationsareformed.Whenanalysingthebehaviouroftheeconomytheysimplytreatexpectationsasexogenousorgiven.Expectationsareoneoftheinputstotheanalysis.Theanalysiscandisplaytheconsequencesofachangeinexpectations.Forexample,anincreaseinexpectedfutureprofitsmightincreasethesharepriceofafirm.Butthisassumptionofexogenousexpectationsmeansthattheanalysisdoesnotinvestigatethecauseofthechangeinexpectations.Inparticular,itisunrelatedtootherpartsoftheanalysis.Withgivenexpectations,thereisnoautomaticfeedbackfromrisingoutputtoexpectationsofhigherprofitsinthefuture.Thus,atbest,economistsusingexogenousexpectationsintheiranalysisgiveanincompleteaccountofhowtheeconomyworks.Atworsttheycompletelyneglectsomeinevitablefeed-backfromthevariablestheyareanalysingtotheexpectationsthatwereaninputtotheanalysis.Ontheotherhand,sincemodellingexpectationsremainsacontentiousissue,propo-nentsofthisapproachmightarguethatthevarioustypesofpossiblefeedbackonexpectationscanbeexploredinanadhocmanner. Bubbleologyandfinancialmarkets299ExtrapolativeexpectationsOnesimplewaytomakeexpectationsendogenous,ordeter-minedbywhatisgoingonelsewhereintheanalysis,whendiscussingtheexistenceorotherwiseofbubbles,istoassumethatpeopleforecastsomevariable,forexamplefutureprofits,byextrapolatingthebehaviourofprofitsintherecentpast,orextrapolatepastinflationinordertoformexpectationsofinflationinthenearfuture.Proponentsofthisapproachsuggestthatitoffersasimpleruleofthumbandcorrespondstowhatmanypeopleseemtodointherealworld.RationalexpectationsSupposetherateofmoneygrowthissteadilyincreasingandinflationissteadilyaccelerating.Ifforecastinginflationthenextrapolatingpastinflationrateswillpersistentlyunder-forecastfutureinflation.Manyeconomistsbelievethatitisimplausiblethatpeoplewillcontinuetouseaforecastingrulethatmakesthesamemistake(under-forecastingoffutureinflation,say)periodafterperiod.Thehypothesisofrationalexpectationsmakestheoppositeassumption:onaverage,peopleguessthefuturecorrectly.Theydonotuseforecastingsystemsthatsystematicallygivetoolowaforecastortoohighaforecast.Anytendencyforexpectationstobesystematicallywrongwillquicklybedetectedandputright.Thisinnowaysaysthateverybodygetseverythingexactlyrightallthetime.Weliveinariskyworldwhereunforeseeablethingsarealwayshappening.Expectationswillbefulfilledonlyrarely.Rationalexpectationssaysthatpeoplemakegooduseoftheinformationthatisavailabletodayanddonotmakeforecaststhatarealreadyknowablyincorrect.Onlygenuinelyunforeseeablethingscausepresentforecaststogowrong.Sometimespeoplewillunder-predictandsometimestheywillover-predict.Butanysystematictendencytodooneorotherwillbenoticedandthebasisofexpectationsformationwillbeamendeduntilguessesareonaveragecorrect.BubblesandtheformationofexpectationsTheexistenceorotherwiseofbubblesdependsonwhichoneofthesemodelsofexpectationsoneapplies.Theadoptionofthe 300EconomicsforFinancialMarketsrationalexpectationsassumptionhasclarifiedconsiderablythenatureofpricebubbles.Withrationalexpectationsaresearchercanspecifyamodelofbubbles,whichcanthenbetested.Iftheexpectedrateofmarketpricechangeinfluencesthecurrentmarketpricetheresearcherhasamodeltoworkwith.Thisisnottosaythatthisisstraightforward.Thereisanindetermi-nacyinthemodelasaresearcherisinfactfacedwithsomethingtoexplain,themarketequilibriumprice,withtwovariables,themarketpriceandtheexpectedrateofmarketpricechange,bothofwhichareinterrelatedwithintheeco-nomicsystem.Abubblecanarisewhentheactualmarketpricedependspositivelyonitsownexpectedrateofchange,asnormallyoccursinassetmarkets.Sinceagentsformingrationalexpecta-tionsdonotmakesystematicpredictionerrors,thepositiverelationshipbetweenpriceanditsexpectedrateofchangeimpliesasimilarrelationshipbetweenpriceanditsactualrateofchange.Insuchconditions,thearbitrary,self-fulfillingexpectationofpricechangesmaydriveactualpricechangesindependentlyofmarketfundamentals.Thissituationisreferredtoasapricebubble.Anexplicitdefinitionofmarketfundamentalsdependsonaparticularmodel’sstructure;indeed,theverynotionofabubblecanmakenosenseintheabsenceofaprecisemodeldetailingamarketsoperation.Withoutsuchamodel,itisimpossiblebothtodefinemarketfundamentalsandtothenisolatethemfromthepresence,orotherwise,ofabubble.BubblesandtheefficientmarkethypothesisEfficientmarkettheory(EMH)appliesthetheoryofrationalexpectationstothepricingofsecurities.TheEMHcomesinthreeversions:theweakform,thesemi-strongform,andthestrongform.Theweakformofthe(EMH)assertsthatpricesfullyreflecttheinformationcontainedinthehistoricalsequenceofprices.Thus,investorscannotdeviseaninvestmentstrategytoyieldabnormalprofitsonthebasisofananalysisofpastpricepatterns. Bubbleologyandfinancialmarkets301Thesemi-strongformoftheEMHassertsthatcurrentstockpricesreflectnotonlyhistoricalpriceinformationbutalsoallpubliclyavailableinformationrelevanttoacompany’ssecu-rities.Ifmarketsareefficientinthissense,thenananalysisofbalancesheets,incomestatements,announcementsofdividendchangesorstocksplitsoranyotherpublicinforma-tionaboutacompany(thetechniqueoffundamentalanaly-sis)willnotyieldabnormaleconomicprofits.ThestrongformoftheEMHassertsthatallinformationthatisknowntoanymarketparticipantaboutacompany,isfullyreflectedinmarketprices.Hence,noteventhosewithprivilegedinsideinformationcanmakeuseofittosecuresuperiorinvestmentresults.Thereisperfectrevelationofallprivateinformationinmarketprices.Thetheoryofrationalexpectationsstatesthatexpectationswillnotdifferfromoptimalforecasts(thebestguessesofthefuture)usingallavailableinformation.Rationalexpectationstheorymakessensebecauseitiscostlyforpeoplenottohavethebestforecastofthefuture.Thetheoryhastwoimportantimplications:ifthereisachangeinthewayavariablemoves,therewillbeachangeinthewayexpectationsofthisvariableareformed,tootheforecasterrorsofexpectationsareunpredictable.ThelessonsoftheEMHarethatbubblesareimpossiblebecausemarketsare‘efficient’,i.e.,pricesreflectallavailableinformationaboutanasset.AdherentsofEMH,believingthatstocksarealwayscorrectlypriced,tendtodenyaconnectionbetweenexcessivespeculationandsubsequenteconomiccri-ses.However,thenecessaryassumptionsunderlyingtheEMHmustbesimultaneouslyheld.Thusitisnecessarytoexaminetheextenttowhichtheydohold.Thestockmarketcrashon19October1987shouldmakeusquestionthevalidityofefficientmarketsandrationalexpectations.EMHcriticsdonotbelievethatarationalmarketplacecouldhaveproducedsuchamassiveswinginshareprices.Towhatdegreeshouldthestockmarketcrashmakeusdoubtthevalidityofrationalexpectationsandefficientmarketstheory?Nothinginrationalexpectationstheoryrulesoutlargeone-daychangesinstockprices.Alargechangeinstockpricescan 302EconomicsforFinancialMarketsresultfromnewinformationthatproducesadramaticchangeinoptimalforecastsofthefuturevaluationoffirms.Somefinancialeconomistshavepointedoutthattherearemanypossibleexplanationsforwhyrationalexplanationsofthefuturevalueoffirmsdroppeddramaticallyon19October1987:movesinCongresstorestrictcorporatetake-overs,thedis-appointingperformanceofthetradedeficit,congressionalfailuretoreducethebudgetdeficitsubstantially,increasedfearsofinflation,thedeclineofthedollar,andincreasedfearsoffinancialstressinthebankingindustry.Otherfinancialeconomistsdoubtwhethertheseexplanationsareenoughtoexplainthestockmarketdropbecausenoneofthesemarketfundamentalsseemsimportantenough.Onelessonfromthe1987BlackMondaystockmarketcrashappearstobethatfactorsotherthanmarketfundamentalsmayhavehadaneffectonstockprices.Thecrashof1987hasthereforeconvincedmanyfinancialeconomiststhatthestrongerversionofefficientmarketstheory,whichstatesthatassetpricesreflectthetruefundamental(intrinsic)valueofsecurities,isinfactincorrect.Theyattributealargeroleinthedeterminationofstockpricestomarketpsychologyandtotheinstitutionalnatureofthemarketplace.However,nothinginthisviewcontradictsthebasicreasoningbehindrationalexpectationsofefficientmarketstheory,i.e.,thatmarketparticipantseliminateunexploitedprofitopportunities.Eventhoughstockmarketpricesmaynotalwayssolelyreflectmarketfundamentals,thisdoesnotmeanthatrationalexpec-tationsdonothold.Aslongasthestockmarketcrashwasunpredictable,thebasiclessonsofthetheoryofrationalexpectationshold.RationalbubblesFamousdocumented‘first’bubbles(Garber,1990)includetheSouthSeasharepricebubbleofthe1720sandtheTulipmaniabubble.Inthelattercase,thepriceoftulipbulbsrocketedbetweenNovember1636andJanuary1637onlytocollapsesuddenlyinFebruary1637,andby1639thepricehadfallentoaround1/200thof1percentofitspeakvalue.Theincreaseinstockpricesinthe1920sandsubsequent‘crash’in1929,thestockmarketcrashof1987,andtheriseofthedollarbetween Bubbleologyandfinancialmarkets3031982and1985anditssubsequentfall,havealsobeeninterpretedintermsofaself-fulfillingbubble.Keynes(1936),asmentionedearlier,isnotedforhisobserva-tionthatstockpricesmaynotbegovernedbyanobjectiveviewof‘fundamentals’butbywhat‘averageopinionexpectsaverageopiniontobe’.Hisanalogyfortheforecastingofstockpriceswasthatoftryingtoforecastthewinnerofabeautycontest.Objectivebeautyisnotnecessarilytheissue;whatisimportantishowonethinkstheotherjudges’perceptionofbeautywillbereflectedintheirvotingpatterns.Rationalbubblesarisebecauseoftheindeterminateaspectofsolutionstorationalexpectationsmodels,whichforstocksisimplicitlyreflectedinwhatisknownastheEulerequationforstockprices.TheEulerequationstatesthatthepriceyouarepreparedtopaytodayforastockdependsonthepriceyouthinkyoucanobtainatsomepointinthefuture.ThestandardformoftheEulerequationdeterminesasequenceofpricesbutdoesnot‘pindown’auniquepricelevel.However,ingeneraltheEulerequationdoesnotruleoutthepossibilitythatthepricemaycontainanexplosivebubble.Whileonecancertainlytryandexplainprolongedrisesorfallsinstockpricesasduetosomekindofirrationalbehav-ioursuchas‘herding’,or‘marketpsychology’,neverthelessrecentworkemphasizesthatsuchsharpmovementsor‘bub-bles’maybeconsistentwiththeassumptionofrationalbehaviour.Eveniftradersareperfectlyrational,theactualstockpricemaycontaina‘bubbleelement’andthereforetherecanbeadivergencebetweenthestockpriceanditsfunda-mentalvalue.Soproponentsofrationalbubblesattempttodemonstratehowthemarketpricesofstocksmaydeviate,possiblysub-stantiallyfromtheirfundamentalvaluesevenwhenagentsarehomogenous,rational,andthemarketisinformationallyeffi-cient.Todothistheymustshowthatthemarketpricemayequalitsfundamentalvalueplusa‘bubbleterm’,andyetthestockwillbewillinglyheldbyrationalagentsandnosuper-normalprofitscanbemade.Itmustbestressedthatfirmconclusionsabouttheexist-enceorotherwiseofspeculativebubblesaredifficulttoestablish.Therearesevereeconometricdifficultiesintestingforrationalbubbles.Suchtestscriticallydependonthecorrectspecificationforassetreturns.Rejectionoftheno-bubblehypothesismaywellbeduetomis-specifyingtheunderlyingmodelofthefundamentals. 304EconomicsforFinancialMarketsSomebubblesinhistoryItisinstructivetoexaminesomeofthemostfamous‘bubbles’inhistorythathaveendedinspeculativecollapses.ThemostanalysedhavebeentheTulipmaniainHollandin1636,theSouthSeaBubbleinEngland1711–1720,andthe1929WallStreetCrash.Recentempiricalwork,particularlyonTulipma-niaandtheSouthSeaBubble(Garber,1998),hascastdoubtsonwhetherthesecouldbeclassifiedas‘bubbles’.Butitisstillusefultopaintthepicture.Tulipmania–Hollandin1636ThefirstaccountoftulipsinEuropeisfrom1559whenacollectorofexoticflora,CouncillorHewart,receivedaconsign-mentoftulipbulbsfromafriendinConstantinople,whichheplantedinhisgardeninAugsberg,Germany.Histulipsdrewagooddealofattentionandinthefollowingyearsthisflowerbecamemoreandmorepopularamongtheupperclasses,particularlyinGermanyandHolland,whereitbecamethecustomtoorderbulbsatexorbitantpricesdirectlyfromConstantinople.Upto1634thiscustombecameincreasinglycommon,andfromthatyearaffluentsocietyinHollandconsideredalackofatulipcollectiontobeproofofpoortaste.Yearbyyeartulipbulbpricesrose,finallyreachingastro-nomicheights.Accordingtooriginalaccountsofthepeakofthetulipmania,inonedealthefollowingpricewaspaidforonetulipbulboftherareSemperAugustusvariety:4600florins,anewcarriage,twograymaresandacompletebridleandharness.Asafattedoxatthattimecost120florins,4600florinswasanawfullotofmoney!Onesinglebulbofanotherrarevariety,Viceroy,wassoldfor24carriageloadsofgrain,eightfathogs,fourcows,fourbarrelsofale,1000poundsofbutter,andafewtonsofcheese.Inearly1636demandfortulipbulbshadrisensodrasticallythatpeoplestartedtotradethemonexchangesinanumberofDutchtowns.Tulipswerenolongerboughtonlybywell-to-docollectorsbutalsobyagentsandspeculators.Atthesmallestpricedroptheyboughtup,toselllaterataprofit.Tofacilitatetradingonmargin,tulipoptionswereintroduced,requiringamargindepositofonly10–20percent.Ordinarypeopleinallbusinesssectorsstartedtoselloffassetstoinvestinthisattractivemarket. Bubbleologyandfinancialmarkets305TheDutchtulipboomalsodrewattentionfromabroadandcapitalbegantostreamintothemarket.Thiscapitalforceduppricesforland,propertyandluxurygoods,aswellastulips,tonewrecordheights.Fortunesgrewandagrowingnouveaurichegroupwasaddedtotheoldupperclasses.Thisnewaffluentclasshadearneditsmoneyfrom,andreinvestedin,tulipbulbs.ThestoryistoldofabrewerinUtrechtwhowentsofarastoexchangehisbreweryforthreevaluabletulipbulbs.InSeptemberandOctoberof1636marketpsychologybegantoalteranddoubtsbegantoemerge.Howcouldonebesurethatthreetulipbulbswereworthasmuchasabrewery?Suppressedmirthbegantobeheard.Whosaidatulipbulbwasworthanythingatall?Themarketwasseizedbypanicandpricesbegantoplummet.Manyofthenouveaurichehadtofacethefactthattheyownedafortuneconsistingonlyoftulipbulbswhichnobodywanted,lessbrokercashloanswhichtheycouldnotrepay.ThegovernmenttriedtofindacompromisebydeclaringalltulipcontractsfrombeforeNovember1636asbeinginvalid,whileallsubsequentcontractswouldbehonouredat10percentoftheoriginalvalue.Butpricesdroppedbelowthis10percentandthenumberofbankruptciesincreaseddaybyday.TheDutchtulipmaniawasfollowedbyadepressionfromwhichittookthecountrymanyyearstorecover.Garber(1989)pointsoutthatthestandardversionoftulipmanianeglectsdiscussionaboutwhatthemarketfunda-mentalpriceofbulbsshouldhavebeen.Toformanexpectationaboutthepriceoftulipbulbs,Garbercollecteddataonbulbpricepatternsforvarioushighlyvaluedtulipbulbs.Hefoundthattheextremelyhighpricesreportedforrarebulbsandtheirrapiddecline,reflectednormalpricingbehaviourinbulbmarketsandcannotbeinterpretedasevidenceofmarketirrationality.Garberpointsoutthatserioustradersignoredthemarketandparticipantsinthemarkethadalmostnowealthanyway.Garberconcludesthattulippricesatthetimecouldbeexplainedbymarketfundamentalsandthattulipmaniadoesnotqualifyasbeingabubble.Itmustbestressedthathisfindingshavebeenhotlydisputed.TheSouthSeaBubbleAsecondinstructiveexampleofbubbleswasthespeculationinEnglandatthebeginningoftheeighteenthcentury.Acompany,laterknownunderthename‘TheSouthSeaBubble’,startedin 306EconomicsforFinancialMarkets1711whentheEarlofOxfordfoundedtheSouthSeaCompany,financedbyanumberofthemerchantsofthattime.Thecompany’sfullnamewas‘TheGovernorandCompanyoftheMerchantsofGreatBritaintotheSouthSeasandotherpartsofAmericafortheencouragementoftheFishing’.Thecompanyacquiredalmost10millionpoundsoftheBritishnationaldebt,againstaguaranteedannuityof6percent,andthemonopolyofalltradingwithLatinAmerica.Ashorttimeafterthecompany’sfounding,rumoursofincredibleprofitsfromtheSouthSeatradingarose,whereEnglishgoodscouldbebarteredforgoldandsilverfromthe‘inexhaustible’minesofPeruandMexico.Infact,theSpanishcolonialpowerallowedonlyoneEnglishshiptocallperyear,forwhichitchargedonequarterofallprofitsand5percentofturnover.OnthestockexchangetheSouthSeastockledaquietexistence,thepriceoftenmovingonlytwoorthreepointsoveramonth.In1717theKingofEnglandrecommendedthatthenationaldebtbe‘privatized’oncemore.Thecountry’stwolargefinancialinstitutions,theBankofEnglandandtheSouthSeaCompany,eachsubmittedaproposedsolutionand,afterheatedparlia-mentarydebate,itwasresolvedtoallowtheSouthSeaCompanytoacquireafurtherdebtliabilityataninterestrateof5percentperyear.Butin1719aneventtookplaceinFrancethatwastobeofgreatsignificancefortheEnglishcompany.Awell-to-domannamedJohnLawhadfoundedacompanyinParis,‘Com-pagnied’Occident’,totradewith,andcolonize,theAmericanStateofMississippi.ByaseriesofmanipulationsJohnLawsucceededinstartingamassivewaveofspeculationinthiscompany’sstock,thepricerisingfrom466francson9Augustto1705francson2December1719.BuyerswereFrenchandforeignersalike,whichcausedtheBritishAmbassadortorequestHisMajesty’sGovernmenttodosomethingtostopthemassiveflowofEnglishcapitaltothe‘MississippiBubble’ontheFrenchstockexchange.TheMississippiBubblecollapsedon2December1719,andintheensuingcrashinvestors,seekingprofitableopportunities,movedtheirfundsfromFrancetoEngland.TheopportunitytoprivatizetheUKnationaldebtprovidedaninterestingopportunityfortheprincipalstockholdersintheBritishSouthSeaCompany,whonowofferedtotakeovertheentiredebtoftheEnglishState.On22January1720theHouseofCommonsappointedacommitteetoconsidertheproposal. Bubbleologyandfinancialmarkets307Despitemanywarnings,on2FebruarythedecisionwastakentosubmitabilltoParliament.Investorsweredelightedatthisprospectoffurthercapitalizationofthecompanyandoverafewdaysthepriceroseto£176,supportedbytheinflowoffundsfromFrancebyinvestorswhowereseekingnewprofitableopportunities.Duringfurtherreadingsofthebillnewrumoursstartedtocirculateontheunbelievableprofitswhichcouldbemadeandstocksrosefurthertoapriceof£317.Evenatthispricethecompany’soriginalfoundersandco-directorscouldreapacapitalgainthatwasenormousbythestandardsofthattime,andinavirtuallyinactivecompany.Thiswhettedtheirappetitesformore,andnewpositiverumourswerecirculatedon12Aprilandfreshstockwassubscribedtoforonemillionpoundsatapriceof£300.Theissuewassubscribedtwiceoverandafewdayslaterstockwastradedat£340.Thecompanythendeclaredthata10percentdividendwouldbepaidonallnewandoldstockandafurthernewsubscriptionwasinvitedforonemillionpoundsatapriceof£400.Thiswasalsoover-subscribed.Thecompanywasstillalmosttotallyinactive.Manyothercompaniesjumpedonthisspeculativeband-wagonissuingtheirownshares.Howeveron11June1720theKingproclaimedanumberofthesecompaniestobe‘publicnuisances’andtradingintheirstockswasprohibitedonpenaltyofafine.Alistof104prohibitedcompanies,describedbyMackay(1841)below,werebanned.Despitethegovernment’sendeavoursnewbubblesappearedeverysingledayandthespeculationfevercontinuedtorise.Figure13.1chartstheprogressoftheSouthSeabubble.TheSouthSeaCompanywastradedatapriceof£550on28May1720.Fromthisalreadyimpressivelevel,duringJunethepriceroseabove£700.Inthisperiodpricemovementswereextremelynervous,withgreatperiodicshifts.Onasingleday,3June,thepricethusdroppedbeforenoonto£650,toriseagainintheafternoonto£750.Manylargeinvestorsusedthehighpricestotakeprofits,whichwerereinvestedinanythingfromlandandcommoditiestorealestateandotherstocks.However,othersboughttheSouthSeaCompany’sstock,oneofthemthephysicist,IsaacNewton.Duringthestock’searlyriseshehadsoldallhisSouthSeastock,cashingaprofitof£7000.Inmidsummerheboughtagain,atransactionwhichwouldcometocosthim£20000.AtthebeginningofJune,SouthSeastockroseagainandforashortenchantedmoment,on24June1720,thesecuritywas 308EconomicsforFinancialMarkets1000.00940.00880.00820.00760.00700.00640.00580.00520.00460.00Bill400.00passed340.00280.00220.00160.00100.0040.00Oct.Jan.Apr.Jul.Oct.17191720Figure13.1TheSouthSeaBubble.(Source:ThePsychologyofFinance&Trade.JohnWiley&SonsLtd.)tradedat£1050.Asonlyfewwereaware,thetimewasrunningoutforinvestors.Thoseintheknowwerethecompany’soriginalfoundersanditsBoardChairman,whohadusedtheearlierhighpricestogetridoftheirownstock.AtthebeginningofAugustthisominousfactbegantoleaktothegeneralpublicandthestockpricebegantofallslowlyandsteadily.On31AugusttheSouthSeaManagementannouncedthatanannualdividendof50percentwouldbepaidforthefollowing12years.Thiswouldhavecompletelydrainedthecompanyofcashandthenewsdidnotstoptheinvestors’increasingunease.On1Septemberthestockcontinuedtofallandwhenitreached£725twodayslater,panicbrokeout.Thesecuritywentthroughthefloorovertherestofthemonthandwhenthecompany’sbankwasdeclaredbankrupton24Septemberthefallaccelerated.Onthelastdayofthemonththesharecouldbeboughtatapriceof£150.Inonlythreemonthsithadfallenby85percent.Thecompanywasfinallydissolvedin1855anditsstockconvertedtobonds.Inits140yearsofexistencethecompanyneversucceededintradingintheSouthSeasonanynote-worthyscale. Bubbleologyandfinancialmarkets309TheWallStreetCrashof1929The1929WallStreetCrashwastheconclusionofoneofhistory’slargestepisodesofmadspeculation.Foranumberofyearsupto1924theAmericanDowJonesIndustrialIndexfluctuatedwithinarelativelynarrowpriceintervalwithstrongsellingpressurewheneveritreached110.From1921,whenthestockmarketwasverydepressed,to1928,industrialoutputroseby4percentannuallyandby15percentfrom1928to1929.Inflationwaslowandnewindustriessproutedfortheverywhere.Thisrisingoptimism,combinedwitheasyaccesstocheapmoney,stimulatedstockinvestorsandafteratemporaryreversalin1926almostnomonthpassedwithoutariseinstockscreatinganewgenerationofrichinvestors.Investmenttrustsincreasedinnumberasstockinvestmentsroseinpopularity.Fromaround40companiesbefore1921,thenumberroseto160atthebeginningof1927and300attheendofthesameyear.Fromthebeginningof1927totheautumnof1929thetotalassetsofinvestmenttrustsincreasedmorethan10-foldandtherewasalmostunlimitedconfidenceinthesecompanies.On24October1929,tradingreached12millionstocks.Nervousness,however,hadsetinandapanicwasevident.Asthesituationwasclearlygettingoutofhand,on25OctoberPresidentHoovermadethefollowingstatement:‘Thefundamentalbusi-nessofthecountry,thatis,productionanddistributionofcommodities,isonasoundandprosperousbasis’.Hoover’sdeclarationhadthesamereassuringeffectasapilotannouncingthattheenginewasnotonfire.Panicgrewandinthenextfewdayspricescontinuedtofall.Thisculminatedon29Octoberwhen,inawaveofenforcedsales,16millionstockswererealizedatanypricegoing.Thestorygoesthatamessengerattheexchangegottheideaofbiddingadollarpershareforalotwithoutbuyers–andgothisdeal.Pricesdidnotstarttostabilizeuntiltheindexreached224,on13November,asshowninFigure13.2.In1930pricesstartedtofalloncemore,continuingtoabottomof58on8July1932.SpeculativebubblestheoryApplyingthespeculativebubblestheory,stockmarketinvest-mentismoreaboutinflatingandburstingspeculativebubblesthanaboutinvestorsmakingrationallong-termforecasts. 310EconomicsforFinancialMarkets400.00375.00350.00Hoover:‘Thefundamentalbusinessofthecountry,thatis,productionanddistributionofcommodities,325.00isonasoundandprosperousbasis.’300.00275.00250.00225.00200.00175.00150.00125.00100.0075.0050.0025.000.00Jan.Apr.Jul.Oct.Jan.Apr.Jul.Oct.Jan.Apr.Jul.Oct.Jan.Apr.Jul.Oct.Jan.Apr.Jul.Oct.Jan.Apr.Jul.Oct.192719281929193019311932Figure13.2The1929stockmarketcrash.(Source:ThePsychologyofFinance&Trade.JohnWiley&SonsLtd.)Underthespeculativebubbletheoryanasset’spricecanbebidupaboveitsintrinsicvaluebecausesomemarketparticipantsbelievethatotherswillbewillingtopaystillmoreforittomorrow.Forawhilethisbeliefisself-sustainingandthemarketbooms,buteventuallyparticipantslosefaiththatpricescanrisefurtherandthemarketcrashes.Thistheory,alsonamedbyMalkiel(2000)the‘CastlesintheAir’Theory,baseduponthethrillsofmakingakillingbysellingcastlesintheair,haslongantecedents.Examplesinhistoryabound.Two,ofitsbestknownexamplesaretheTulipBulbManiaandtheSouthSeaBubble,discussedearlier.UndertheTulipBulbTheoryof1593,thepriceoftulipsrosetotheextentthat,priortoitscollapse,onetulipwouldhavefedaship’screwforayear.TheSouthSeaBubbleof1711offeredtherightstomonopoliesintheSouthSeaenablingfortunestobemadeandlost.MacKay(1841)providesanimpressivelistofSouthSeaBubbleemulators.Companieswerecreatedto:designawheelofperpetualmotionbuildhospitalsforbastardchildrenbuildshipstodefeatpirates Bubbleologyandfinancialmarkets311improvetheartofmakingsoapextractsilverfromlead.Oneofthemostoutrageouscompanieswasonewhichwasdesignedtobe‘acompanyforcarryingonanundertakingofgreatadvantagebutnobodyknewwhatitwas’.Thepropagatorofthiscompanytook£2000inoneafternoonandwasneverseenagain!Thesharesofallthesecompanieshadthecharacteristicsofspeculativebubbles.RationalspeculativebubblesHardouvelis(1988)hasarguedthatspeculativebubblesmaybetriggeredbyanextraneouseventthatisunrelatedtofunda-mentaleconomicconditions.Forexample,onegroupofinvest-orsbuyswiththeexpectationofalargecapitalgain,andothersfollowsuit,withoutpayingproperattentiontoeconomicfactors,suchasfuturedividendsorinterestrates.Ifsuchbehaviourpersists,itmayfeedonitselfasconsecutivewavesofbuyingincreaseprices.Speculativebubblesmaysubsequentlyburstverysuddenly.Anovervaluedmarketisfragileandarelativelyunimportantpieceof‘bad’newsmayeasilycreatepessimismandsetoffasellingwave.Thetraditionalmethodofsearchingformarketovervaluationorspeculativebubblescountsthenumberofunusuallyhighreturnsduringthesuspectedbubbleperiodandassessesthelikelihoodthatthetotalnumberofthesehighreturnscouldhavearisenfromchance(BlanchardandWatson,1982).Anunusuallyhighreturn(orapositive‘abnormal’return)isareturnhigherthantherisk-freerateplustheusualriskpremiumnecessarytocompensaterisk-averseshareholdersfortheuncertaintyassociatedwiththeirsecurityreturns.Intheabsenceofaspeculativebubble,averylargenumberofunusuallyhighreturnswouldnormallyoccurbychanceonlywithasmallprobability.Hence,alargenumberofunusuallyhighreturnsconstitutesevidenceconsistentwiththepresenceofspeculativebubbles.Unfortunately,althoughsimple,thetraditionaltesthaslowstatisticalpowertodetectspeculativebubbles;sharepricesareveryvolatileandtheirswingsgeneratebothlargepositiveandlargenegativereturns.Thelattertendtomaskanyexistingbubbleevidence. 312EconomicsforFinancialMarketsInordertoconstructamorepowerfultestforbubbles,itisnecessarytoformulateamorepreciseeconomicaccountofthedevelopmentofthebubble.Onecanimaginemanydiffer-entscenariosofmarketovervaluation,butanalysisrestrictsthepossiblescenariostothoseinwhichinvestorsknowthatthemarketisovervaluedyetshownospecialdesiretoliqui-datetheirpositionsandcontinuetobuyorsellastheywouldintheabsenceofbubbles.Thisisarealisticworkingassump-tionfortheperiodbeforeOctober1987.RobertSchiller(1987)providessurveyevidenceindictingthat,beforeOctober1987,71.7percentofindividualinvestorsand84.3percentofinstitutionalinvestorsthoughtthatthemarketwasover-valuedatthetime.Schillerarguedthatthecrashwasgen-eratedbywhathecallsa‘feedbackloop’.Afterafirstpricedeclineinvestorssold,notbasedonfundamentals,butbecausetheywereworriedaboutwhatwasgoingonandaboutmarketirrationality.Thedropdidnotstopuntilenoughpeoplestartedtohaveopposingfeelings.Explainingwhyinvestorsdidnotgetoutofanovervaluedmarketismoredifficult.Onecouldarguethatthepresenceofhighlyliquidfuturesmarketsandassociatedtradingstrate-gies,suchasportfolioinsurance,ledinvestorstothefalsebeliefthattheycouldenjoylargepositivereturnsinanupwardmarketyetstillavoidsufferingalargelossifthemarkettookabigplunge.AnalternativeexplanationoutlinedabovebyHardouvelis(1988)isonethatdoesnotdependonsomesortofcollectiveirrationality.Withintheeconomicsliteraturethisisknownasthe‘rationalspeculativebubblehypothesis’.The‘bubblepremium’Inthecaseofarationalspeculativebubble,investorsknowthatthebubblemaycrashandthattheywillnotbeabletogetoutoncethecrashstarts,buttheyremaininthemarketbecausetheybelieve(forwhateverreason)thatthereisagoodprobabilitythatthebubblewillcontinuetogrow,bringingthemlargepositivereturns.Thesereturnsareexpectedtobehigherthantherisk-freerateplustheusualriskpremiumintheabsenceofbubbles,andlargeenoughtocompensatethemexactlyfortheprobabilityofthebubblecrashandalargeone-timenegativereturn.Hence,itisrationalforinvestorstostayinthemarket. Bubbleologyandfinancialmarkets313Theexpectedextrareturnwhennobubblecrashoccurscanbecalledthe‘bubblepremium’.Thetheoryimpliesthatthebubblepremiumisnotonlypositive,butalsoincreasesduringthelifetimeofthebubble.Thetimetrendinthebubblepremiumderivesfromtheexplosivenatureofthebubblecomponentoftheshareprice.Astimegoeson,thebubblecomponentofthesharepricegrowslargerandlargerrelativetothefundamentalcomponents.Thisgrowthimpliesthatwiththepassageoftime,theexpecteddropinthesharepriceinthecaseofabubblecrashgrowslargertoo,necessitatingalargerandlargerbubblepremium. AppendixADiffusionindexes:theirconstructionandinterpretationBurnsandMitchell(1946)observedthatabusinesscycleexpansiondoesnotimplythateveryunderlyingeconomicactivityisexpanding,nordoesabusinesscyclecontractionmeanthateverybusinesscyclefirmhasdecliningsales.Theyfurtherobservedthateconomicactivityhastwotypesofcycles:seenandunseen.Onecycleisinthefluctuationoftheaggregatemeasureitselfandconsequentlyisseen.Butasecondcycle–theunseenordiffusioncycle–existsinthedistributionofcomponentswithinthataggregatebasedonthenumberofexpandingorcontractingsegments.Thisunseencycleisimportantbecauseithelpstomonitorandforecastthepathofthecycle.Inparticular,cyclicalexpansionsorcontrac-tionsdiminishinscopebeforetheycometoanendandcontractionsthatultimatelybecomeseverearewidespreadintheirearlystages.Theconceptofdiffusionismadeoperationalbydefiningitasatimeseriesrepresentingthepercentageofcomponentswithinanaggregatethatareexpanding.Anindexofdiffusioniscalculatedfromthepercentageofcomponentsexpanding(E),thepercentageofcomponentsthatareunchanged(U),andthe1percentageofcomponentsthatarecontracting(C)asE+(2×U),whereE+U+C=100%.Arelatedconceptisthenetpercentrising(NPR),whichisdefinedasE–C.About15regionalpurchasingmanagersurveys,includingtheBusinessOutlookSurveyofthePhiladelphiaFed,aretakenaroundthecountryandmanyofthosesurveysreporttheirresultsusingtheNPRformula,whichcanrangebetween+100and–100.SinceNPRsimplytakesthedifferencebetweenthe 316EconomicsforFinancialMarketspercentageoftheresponsesreporting‘higher’andtheper-centagereporting‘lower’(higher–lower),theboundsareclear.Ifalltheresponsesarehigher,then100–0percent,or+100,istheupperbound,whileifalltheresponsesarelower,then0–100percent,or–100,determinesthelowerbound.ThisistheformatinwhichthePhiladelphiaFeddiffusionindex,discussedinChapter7,isreported.Ontheotherhand,theNationalAssociationofPurchasingManagement’ssurveyresults(discussedinChapter7)arecompiledintoadiffusionindex(DI)thatisboundedby0and100percent.TheDIiscalculatedas100×(higher+(same/2)),wherehigherrepresentsthepercentageofthesamplereportinganincrease,andsamerepresentsthepercentageofthetotalreportingnochange.Notethatthosereportinglowerresponsesareexcluded.Therelationshipbetweenthesetwosummarymeasures,theNPRandtheDI,isillustratedbelow.Howdoyoucomparethetwomethods?Considerthebasicinformationusedtocalculatebothmeas-ures,thatis,theshareofthesamplethatishigher,lower,andunchanged.Forexample,assumethatthePhillyFedreportedaNPRreadingfortheirnewordersseriesof+20basedonthefollowingresponses:higher,30percent;same,60percent;lower,10percent.ThentheNPRequalsthepercentageofthesamplereportinghigherminusthepercentagereportinglower,thatis,30–10percent,or20percent,andthatisexpressedasa+20reading.TheDI,however,is30+(60/2)percent,or60percent.Therelationshipbetweenthetwomeasuresis:NPR+2×(DI–50)whereNPRisthenetpercentagerising(e.g.+20)andDIistheNAPM-typediffusionindex(e.g.60percent).Alternatively,theidentitycanbeexpressedas:DI=50+(NPR/2)TherelationshipbetweentheaggregatetimeseriesandthediffusionindexisshowninFigureA.1.Therearefourstagesofthediffusionindexanditscorrespondingphaseintheaggre-gatecycle.Stage1occurswhenthediffusionindexmovesup AppendixA317from50to100percent(orsimplywhentheindexisabove50percentandrising),whichimpliesthattheaggregateseriesisincreasingatanincreasingrate.Instage2,thediffusionindexisdecliningfromitsupperboundof100to50percent(orsimplytheindexmovesfromahighertoalowernumberabove50percent);thisimpliesthattheaggregateseriesisincreasingatadecreasingrate.Atstage3,thediffusionindexisbelow50percentanddeclining,whichimpliesthataggregateseriesisdecreasingatanincreasingrate.Finally,stage4takesplacewhenthediffusionindexismovingupfromitslowerboundof0to50percent;thisimpliesthattheaggregateseriesisdecliningatadecreasingrate.AggregateseriesDiffusionindex100%StageStage1250%StageStage340%StageAdiffusionindexthatis:Impliesthattheaggregateseriesis:1Rising(50–100%)Increasingatanincreasingrate2Falling(100–50%)Increasingatadecreasingrate3Falling(50–0%)Decreasingatanincreasingrate4Rising(0%–50%)DecreasingatadecreasingrateFigureA.1Therelationshipbetweentheaggregateseriesandthediffusionindex.(Source:EconomicReview,1971,FederalReserveBankofCleveland.) AppendixBTheconstructionandinterpretationofpriceindicesThisappendixprovidesadditionaldetailsabouttheGNPdeflatorandtheconsumerpriceindex.Knowinghowtheindexesareactuallyputtogethermakesiteasiertounder-standthedifferencesbetweenthetwoandhowtobestinterpretthem.TheGNPdeflatorforasimplifiedeconomyAmuchsimplereconomythanthatoftheUnitedStateswillservetoillustratethecomputationofpriceindexes.TableB.1TableB.1NominalGNPinselectedyearsforasimpleeconomy1992QuantityPriceValueMovies50$2.00$100Apples1000.20200Shirts1010.001001992NominalGNP$4002002Movies100$4.00$400Apples500.60300Shirts2015.003002002NominalGNP$1000 AppendixB319showspriceandquantitydatafor2yearsforaneconomyinwhichonlythreegoodsareproduced:movies,applesandshirts.TheexhibitindicatesthatnominalGNPgrewfrom$400in1992to$1000in2002.Buthowarethesefigurestobeinterpreted?Dotheymeanthatpeoplereallyhadmoreofthethingstheywantedin2002thanin1992?Moreexactly,dotheymeanthatpeoplehad2.5timesasmuch?ThesequestionsarenoteasytoanswerfromaninspectionofTableB.1asitstands.Inthissimpleeconomy,whereonlythreegoodsareproduced,nominalnationalincomegrewfrom$400in1992to$1000in2002.Pricesalsowentupinthattime,though,sopeopledidnotreallyhave2.5timesasmanygoodsasin1992.Aline-by-linecomparisonofthe2yearsshowsthatthefiguresonnominalincomedonottellthewholestory.Clearly,priceswentupsharplybetween1992and2002.Moviescosttwicewhattheyusedto,applesthreetimesasmuch,andshirtshalfagainasmuch.Wenoticealsothatthequantitiesofgoodsproducedhavechanged.Twiceasmanymoviesandshirtswereproducedin2002as1992,butonlyhalfasmanyapples.Ifwewanttoknowhowmuchbetteroffpeoplewerein2002thanin1992,weneedawaytoseparatethequantitychangesthathavetakenplacefromthepricechanges.Onewaytodothisistoaskhowmuchthetotalvalueofoutputwouldhavechangedfrom1992to2002ifpriceshadnotchanged.ThisapproachgivestheresultsshowninTableB.2.There,weseethatthe2002outputof100movies,500apples,and20shirts,whichhadavalueof$1000intermsofthepricesatwhichthegoodswereactuallysold,wouldhavehadavalueofonly$500intermsofthepricesthatprevailedin1992.The$500isthusameasureofrealGNPfor2002.Itisthismeasurethatshouldbecomparedtothe1992GNPof$400ifwewanttoknowwhatreallyhappenedtooutputbetweenthetwoyears.Insteadofhaving250percentmoreoutputin2002thanin1992,asindicatedbythechangeinnominalGNPfrom$400to$1000,thepeopleinthissimpleeconomyreallyhadonlyabout25percentmore,indicatedbythechangeinrealGNPfrom$400to$500.TableB.2showshowthefiguresfromTableB.1canbeadjustedtotakechangingpricesintoaccount.The2002quantitiesaremultipliedby1992pricestogetthevalueofthe2002GNPasitwouldhavebeenifpriceshadnotchanged.Thetotalof2002quantitiesvaluedat1992pricesisameasureofrealGNPfor2002,statedinconstant1992dollars.Theimplicit 320EconomicsforFinancialMarketsTableB.2NominalandrealGNPin2002forasimpleeconomy20022002Valueat1992Valueof2002QuantityPrice2002pricePriceOutputat1992priceMovies100$4.00$400$2.00$200Apples5000.603000.20100Shirts2015.0030010.00200Totals2002nominalGNP=$10002002realGNP=$500GNPdeflatorfor2002,calculatedastheratioof2002nominalGNPto2002realGNP,hasavalueof200.WehavenowseenhowtocomputerealandnominalGNPfor2002directlyfrompriceandquantitydata,withoutusingapriceindextoconvertnominaltorealvalues.Butalthoughwehavenotexplicitlyusedapriceindex,wehavecreatedoneimplicitly.Thisimplicitindex,orimplicitGNPdeflator,istheratioofcurrent-yearnominalGNPtocurrent-yearrealGNPtimes100,asexpressedbytheformula:CurrentyearoutputvaluedatcurrentyearpricesGNPdeflator=×100CurrentyearoutputvaluedatbaseyearpricesApplyingtheformulatothedatainTablesB.1andB.2givesavalueof200forthe2002deflator.TheconsumerpriceindexforasimplifiedeconomyTheconsumerpriceindexdiffersfromtheGNPdeflatorintwoways.First,asmentionedinChapter5,ittakesintoaccountonlythepricesofgoodsandservicestypicallyconsumedbyurbanhouseholds.Second,itiscalculatedaccordingtoaformulathatusesbase-yearquantitiesratherthancurrent-yearquantities.Thefirstdifferencedoesnotmatterforthissimpleeconomyinwhichallgoodsareconsumergoods,buttheseconddifferencedoesmatter,asTableB.3demonstrates.Theconsumerpriceindexcanbecalculatedasthebase-yearmarketbasketofgoodsvaluedatcurrent-yearpricesdividedbythebase-yearmarketbasketvaluedatbase-yearprices, AppendixB321TableB.3CalculationofaconsumerpriceindexforasimplifiedeconomyGood19921992Valueof19922002Valueof1992QuantityPriceQuantityat1992pricePriceOutputat2002priceMovies50$2.00$100$4.00$200Apples1000.202000.60600Shirts1010.0010015.00150Totals$400$950$950CPI=×100=237.5$400multipliedby100.TableB.3showshowsuchanindexcanbecalculatedforthesimpleeconomyusedinTablesB.1andB.2.The1992outputcost$400atthepricesatwhichitwasactuallysold.Ifithadbeensoldat2002prices,itwouldhavecost$950.TheCPIfor2002isthus237.5.TocalculatetheCPIforthissimplifiedeconomy,insteadofaskinghowmuchcurrent-yearoutputwouldhavecostatbase-yearprices,webeginbyaskinghowmuchbase-yearquantitywouldhavecostatcurrent-yearprices.Theindexisthencalculatedastheratioofthetwodifferentvaluationsofbase-yearquantities.ConsumerpriceindexBase-yearmarketbasketvaluedatcurrent-yearprices=×100Base-yearmarketbasketvaluedatbase-yearpricesTheCPIiscalculatedusingbase-yearquantitiesinpartbecausecurrentpricedataareeasiertocollectthanarecurrentoutputdata.Thisindexcanthusbeannouncedeachmonthwithaminimumofdelay.ComparingtheCPIandGNPdeflatorAsTableB.3shows,theCPIfor1992inoursimpleeconomyhadavalueof237.5,whereastheGNPdeflatorfor2002wasonly200.Bothindexeswerecalculatedusingthesame 322EconomicsforFinancialMarketsunderlyingdata,andbothused1992asabaseyear.Which,ifeither,isthetruemeasureofthechangeinthepricelevelbetweenthetwoyears?ThereplyisthatneithertheCPInortheGNPdeflatoristheonlycorrectmeasureofchangeinthepricelevel.Instead,eachistheanswertoadifferentquestion.TheGNPdeflatoristheanswertothequestion:Howmuchmoredidthe2002outputcostatthepricesatwhichitwasactuallysoldthanitwouldhavecostifithadbeensoldat1992pricesinstead?TheCPI,incontrast,istheanswertothequestion:Howmuchmorewouldthe1992outputhavecostifithadbeensoldat2002pricesinsteadofitsactual1992prices?Carefulinspectionofthedatashowswhytheanswerstothetwoquestionsarenotthesame.In1992lotsofapplesandnotverymanyshirtswereproducedincomparisonto2002.Yet,betweenthetwoyears,thepriceofapplesincreased200percentwhilethepriceofshirtsincreasedonly50percent.BecausetheCPIusesbase-yearquantities,itgivesaheavyweighttoapples,whichexperiencedrelativelythegreatestpriceincrease,andnotmuchweighttoshirts,whichexperiencedonlyamodestpriceincrease.Incontrast,theGNPdeflatorusescurrent-yearquantities,therebydownplayingtheimportanceofapplesandemphasizingthatofshirts.WeseenowwhyitisthattheCPItendstohavewhatisreferredtoasanupwardsubstitutionbiasrelativetotheGNPdeflator.ButthatdoesnotmaketheGNPdeflatoratruemeasureofchangeinthecostofliving.ItcouldjustaswellbesaidthattheGNPdeflatorhasadownwardsubstitutionbiasrelativetotheCPIorthateachhasanoppositebiasfromsome‘true’priceindexlyingbetweenthem. AppendixCTitle,AnnouncementTime,andReportingEntitiesforMacroeconomicAnnouncementsTimeShortTitleFullTitleReportingEntity8.30a.m.ConsumerPriceIndex(CPI)ConsumerPriceIndexBureauofLaborStatistics8.30a.m.DurableGoodsOrdersAdvanceReportonDurableGoodsManufacturers’BureauoftheCensusShipmentsandOrders8.30a.m.EmploymentTheEmploymentSituationBureauofLaborStatistics8.30a.m.GrossDomesticProduct(GDP)GrossDomesticProductBureauofEconomicAnalysis8.30a.m.HousingStartsHousingStartsandBuildingPermitsBureauoftheCensus8.30a.m.InitialJoblessClaimsInitialJoblessClaimsBureauofLaborStatistics8.30a.m.LeadingIndicatorsCompositeIndexesofLeading,Coincident,andBureauofEconomicAnalysisLaggingIndicators8.30a.m.PersonalIncomePersonalIncomeandOutlaysBureauofEconomicAnalysis8.30a.m.ProducerPriceIndex(PPI)ProducerPriceIndexesBureauofLaborStatistics8.30a.m.RetailSalesAdvanceRetailSalesBureauoftheCensus8.30a.m.TradeBalanceUSInternationalTradeinGoodsandServicesBureauoftheCensus.BureauofEconomicAnalysis9.15a.m.IndustrialProductionandCapacityIndustrialProductionandCapacityUtilizationFederalReserveBoardUtilization10:00a.m.BusinessInventoriesManufacturingandTrade:InventoriesandSalesBureauoftheCensus10:00a.m.ConsumerConfidenceConsumerConfidenceIndexConferenceBoard10:00a.m.ConstructionSpendingValueofNewConstructionPutinPlaceBureauoftheCensus10:00a.m.FactoryInventoriesManufacturers’Shipments,InventoriesandOrdersBureauoftheCensus10:00a.m.NAPMSurveyNationalAssociationofPurchasingManagementIndexNationalAssociationofPurchasingManagement14:00p.m.NewSingle-FamilyHomeSalesNewOne-FamilyHousesSoldandForSaleBureauoftheCensus AppendixDConsumerandBusinessConfidenceSurveysPerformedbySinceFrequencySectorsSampleFormofPublicationSize(a)BusinessSurveysNationalAssociationof1931MonthlyPurchasingManagers300‘ReportonBusiness’PurchasingManagementTempe,AZDun&BradstreetNewYork1947QuarterlyManufacturing,wholesale,retail3000‘Dun&BradstreetLooksatnon-financialservicesBusiness’1987QuarterlyBusinessexecutivesin149000‘Dun&BradstreetLooksatcountriesBusiness’1990MonthlyManufacturers1000PressReleasesFederalReserveBank1967MonthlyRegionalmanufacturers‘BusinessOutlookSurvey’Philadelphia,PA ManpowerTemporary1977QuarterlyPublicandprivateindustriesinall15000Hiringintentionssurvey;in-pressServices,Inc.Milwaukee,WIregionsreleaseNationalFederationof1973QuarterlySmallbusinessinmanufacturing,2000QuarterlypressreleaseIndependentBusiness(NFIB)wholesale,retailtrade,services,Washington,DCconstruction,andtransportationTheConferenceBoardNew1976QuarterlyAllindustries1600‘ReportonBusinessExpectations’York(b)InvestmentSurveysUSDepartmentof1947QuarterlyAllindustries13000‘SurveyofCurrentBusiness’CommerceWashington,DC(c)ConsumerSurveysABCNews/MoneyMagazine1985Weekly1000ConsumerComfortIndexreporttoNewYorkclientsSindlinger&Co.Wallingford,1957Weekly2000ReportstoclientsPAConferenceBoardNewYork1968Monthly5000Reportstoclients;pressreleasesUniversityofMichigan1946Monthly500ReportstoclientsSurveyResearchInstituteAnnArbor,MI AppendixEUsefulwebaddressesSearchenginesAltaVistawww.altavista.comMSNwww.msn.comYahoowww.yahoo.comNetscapewww.netscape.comAOLwww.aol.comHotbotwww.hotbot.comExcitewww.excite.comInfoseekwww.infoseek.comLycoswww.lycos.comEuroseekwww.euroseek.comCopernicwww.copernic.comUkpluswww.ukplus.comGooglewww.google.comNewspapersTheFinancialTimeswww.ft.comTheTimeswww.the-times.co.ukTheIndependentwww.independent.co.ukTheTelegraphwww.telegraph.co.ukTheSundayTimeswww.sunday-times.co.ukJournalsTheEconomistwww.economist.comRiskwww.risk.comSecuritiesDatawww.secdata.comCapitalDatawww.capitaldata.com AppendixE327InternationalFinancingReviewwww.ifr.comEuroweekwww.euroweek.comEuromoneywww.euromoney.comFuturesandOptionsWorldwww.fow.comTheBankerwww.banker.comInvestorsChroniclewww.investors.chronicle.co.ukTheWallStreetJournalwww.wsj.comInstitutionalInvestorJournalswww.iijournals.comWaterswww.watersinfo.comRiskPublicationswww.riskpublications.comFuturesmagwww.futuresmag.comInternationalFinancingReviewwww.ifrpub.comStocksandCommoditieswww.traders.comNumaWebwww.numa.comInformationserviceprovidersBloombergwww.bloomberg.comElectronicShareInformationwww.esi.comDatastreamwww.datastream.comMarket-eyewww.market-eye.comCNBCwww.cnbc.comKnightRiderwww.rider.comBridgewww.bridge.comReuterswww.reuters.comTelekurswww.telkurs-financial.comExtelwww.info.ft.comInvestmentbanksJPMorganwww.jpmorgan.comLehmanBrotherswww.lehman.comBanqueParibaswww.paribas.comWarburgDillonReadwww.wdr.comSalomonSmithBarneywww.ssb.comMerrillLynchwww.ml.comCommerzbankwww.commerzbank.deKillik&Cowww.killickco.co.uk. 328EconomicsforFinancialMarketsCazenovewww.cazenove.co.uk.GNIwww.gni.co.ukBankersTrustwww.bankerstrust.comSchroderswww.schroders.comNatwestGlobalFinancialMarketwww.natwestgfm.comGoldmanSachswww.gs.comRabobankwww.rabobank.comTheBankofNewYorkwww.bankofny.comHSBCwww.hsbc.co.ukChaseManhattanwww.chase.comFlemingAssetManagementwww.flemings.comCharlesStanleywww.charles-stanley.comBankofAmericawww.bankamerica.comABNAMROHoareGovettwww.abn.comNomurawww.nomura.jpSocieteGeneralewww.socgen.comMorganStanleyDeanWitterwww.ms.comDeutscheMorganGrenfellwww.deutsche-bank.de/globalDresdnerKleinwortBensonwww.dresdner.comCitibankwww.citibank.comCharlesSchwabwww.schwab-europe.comBarclaysCapitalwww.barcap.comRegulatorsandassociationsTheBondMarketAssociationwww.bondmarket.comBritishBankersAssociationwww.bba.org.ukACIwww.aci.org.ukEuropeanBondCommissionwww.ukbe.org.ukIMROwww.imro.orgLAUTROwww.lautro.orgSecuritiesIndustryAssociationwww.sia.comSecuritiesandExchangeCommissionwww.sec.govInternationalOrganisationofSecuritiesCommissionwww.losco.orgInternationalSwapsandDerivativesAssociationwww.isda.orgInternationalSecuritiesMarketAssociationwww.isma.orgFinancialServicesAuthoritywww.fsa.gov AppendixE329InternationalexchangesNewYorkStockExchangewww.nyse.comNewYorkMercantileExchangewww.nyme.comNASDAQwww.nasdaq.comAMEXwww.amex.comLIFFEwww.liffe.comLSEwww.lse.comLMEwww.lme.comFTSEwww.ftse.comCRESTCowww.crestco.co.ukMATIFwww.matif.frSIMEXwww.simex.comChicagoMercantileExchangewww.cme.comChicagoBoardofTradewww.cbot.comChicagoBoardOptionExchangewww.cboe.comDeutscheTermBoursewww.dtb.deDowJoneswww.dowjones.comPhiladelphiaStockExchangewww.phlx.comRatingsagenciesStandardandPoorswww.spglobal.comMoody’swww.moodys.comFitchIBCAwww.fitchibca.comFinancialsoftwareArtisanAnalyticswww.artisananalytics.comRiskManagerwww.riskmanager.comFastwww.fastweb.gsia.cmu.eduTraderTrainerwww.tradertrainer.dkInternationalgovernmentorganizationsEuropeanCommissionhttp://europa.eu.intEuropeanInvestmentBankwww.eib.euEuropeanBankofReconstructionandDevelopmentwww.ebrd.org 330EconomicsforFinancialMarketsEuropeanCentralBankwww.ecb.intBankforInternationalSettlementswww.bis.orgBankofEnglandwww.bankofengland.co.ukHMTreasurywww.hm-treasury.gov.ukUKOfficeforNationalStatisticswww.ons.orgDepartmentofTradeandIndustrywww.dti.orgOrganisationforEconomicCo-operationandDevelopmentwww.oecd.orgNationalBureauofEconomicResearchwww.nber.govTheWorldBankwww.worldbank.orgUnitedNationswww.un.intUnitedNationsConferenceonTradeandDevelopmentwww.unctad.orgUSFederalReservewww.bog.frb.fed.usWorldTradeOrganisationwww.wto.orgInternationalMonetaryFundwww.imf.orgUKinstitutionsBankofEnglandwww.bankofengland.co.ukBankofEngland:Eurowww.bankofengland.co.uk/euro.htmBankofEngland:Practicalwww.bankofengland.co.uk/Issueseuro/piq.htmBankofEngland:Practicalwww.bankofengland.co.uk/PreparationsQ&Aeuro/qanda.htmHMTreasurywww.hm-treasury.gov.ukHMTreasury:Eurowww.euro.gov.ukTheFinancialServicesAuthoritywww.fsa.gov.ukInvestmentManagementRegulatoryOrganisation(IMRO)www.imro.co.ukTheSecuritiesandFuturesAuthority(SFA)www.sfa.org.ukCorporationofLondonwww.cityoflondon.gov.uk AppendixE331EuropeanUnioninstitutionsEuropeanInstitutions(General)europa.eu.int/index.htmEuropeanCommissioneuropa.eu.int/comm/index_en.htmEuropeanParliamenteuropa.europarl.eu.intEconomicandFinancialeuropa.eu.int/comm/Committeeeconomy_finance/Memberstates’euroinformationAustriawww.bmwa.gv.atBelgiumeuro.fgov.beFinlandwww.bof.fiFrancewww.finances.gouv.fr/euroGermanywww.bundesfinanzministerium.deIrelandwww.irlgov.ie/financeItalywww.tesoro.itLuxembourgwww.etat.lu/Fl/TheNetherlandswww.euro.nlorwww.minfin.nlCentralbanksBancad’ltaliawww.bancaditalia.itBancodeEspanawww.bde.esBancodePortugalwww.bportugal.ptBanqueCentraleduLuxembourgwww.bcl.luBanquedeFrancewww.banque-france.frBanqueNationaledeBelgiquewww.bnb.beDanmarksNationalbankwww.nationalbanken.dkDeNederlandscheBankwww.bnb.nlDeutscheBundesbankwww.bundesbank.deEuropeanCentralBank(ECB)www.ecb.intCentralBankofIrelandwww.centralbank.ieNationalBankofGreecewww.bankofgreece.grOesterreichischeNationalbankwww.oenb.co.atSuomenPankkiwww.bof.fiSverigesRiksbankwww.riksbank.seSwissNationalBankwww.snb.ch 332EconomicsforFinancialMarketsUSFederalReserveTheBoardofGovernorsandeachofthe12Reservebankshavetheirownsites.Thesitesofferavarietyofmaterials,includingbasicinformationabouttheeconomy,money,andbanking;regionalandeconomicdata;upcomingconferencesandevents;tourinformation;textofspeeches,publications,articles,reports,andotherresearch;andeconomiceducationmaterials.BoardofGovernorswebsitewww.federalreserve.govAtlantawebsitewww.frbatlanta.orgBostonwebsitewww.bos.frb.orgChicagowebsitewww.frbchi.orgClevelandwebsitewww.clev.frb.orgDallaswebsitewww.dallasfed.orgKansasCitywebsitewww.kc.frb.orgMinneapoliswebsitewoodrow.mpls.frb.fed.usNewYorkwebsitewww.ny.frb.orgPhiladelphiawebsitewww.phil.frb.orgRichmondwebsitewww.rich.frb.orgStLouiswebsitewww.stls.frb.orgSanFranciscowebsitewww.frbsf.orgEconomicsonthenetNourielRoubiniwww.stern.nyu.edu/~nroubini/asia/AsiaHomepage.htmlPaulKrugmanweb.mit.edu/krugman/wwwNationalBureauofwww.nber.orgEconomicResearchNicholasEconomidesraven.stern.nyu.edu/networksHalVariansims.berkeley.edu/resources/infoeconUSeconomicindicatorsCPIstats.bls.gov/news.release/cpi.toc.htmDurableGoodswww.census.gov/ftp/pub/indicatorEmploymentstats.bls.gov:80/newsrels.htm AppendixE333GDPwww.bea.doc.gov/HousingStartswww.census.gov/pub/const/www/c20index.htmlIndustrialProductionwww.borg.frb/fed.us/releases/G17USInternationalTradewww.census.gov/foreign-trade/NAPMwww.napm.org/public/rob/index2.htmlPPIstats.bls.gov/news.release/ppi.toc.htmRetailSaleswww.census.gov/svsd/www/advtable.htmlUnemploymentInsurancewww.dol.gov/dol/public/Claimsmedia/main.htmlPersonalIncomeandWageswww.bea.doc.govandSalariesBureauofEconomicAnalysisInitialClaimsforwww.itsc.state.md.us/data_Unemploymentstats/data_stats.htmlInsuranceHelpWantedandConsumerwww.conference-board.orgConfidenceConferenceBoardConstructionContractswww.mag.fwdodge.comFWDodgeHousingPermitswww.census.gov/pub/const/BureauoftheCensusBuilding_Permits/ 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IndexAccounting,293,294–5BEA,seeBureauofEconomicAgPriceIndex,113–14AnalysisAggregatedemand,2–5,10–11,BeigeBook,224–514–15,84,153Binomialmodel,263–7,278Aggregateeconomicactivity,88,89Black,Fischer,241,242,278Alexander,G.J.,59Black-Scholesmodel,263,267,Americanoptions,244,262,263,278–0267,269Blinder,Alan,238–9Appreciationofcurrency,204,Bonds,6,54–6208–9,213–14,216–17,218,AgPriceIndex,114219basis,257,258Arbitrage,232,245–8,251,255–6,businesscycle,71258–9,269calloptions,269,270–2Arbitrageurs,232,251–4,255–6,consumerconfidence,163259,268–9,272consumerindicators,127,128,Assetmarketapproach,210–19132,134,136Assets:crudeoilprices,113bubbles,297–8,300,310discountrate,7businesscycle,72,82GDPdeflator,107calloptions,267–8,270,271–2,IndexofLeadingIndicators,123275–6,277investmentindicators,141,148capital,294monetarypolicy,84derivatives,240monetization,154financial,13–15NAPMindex,168intangible,293–5putoptions,272KeynesianTheory,13–15tradedeficit,157–8monetarypolicy,84valuation,36–7prices,297–8,302,313Borrowedreserves,18,19,24–5putoptions,272,274–5,276Borrowing,47,51,55reserve,189–90businesscycle,73,74,75substitution,179,181,182discountwindow,23,24–5,supplyofloanablefunds,49,50230–1Averagehourlyearnings,118–19FederalReservetargets,23,24long-termbonds,62–3reporate,257Bailey,J.V.,59seealsodebtBalanceofpayments,156,207BOS,seeBusinessOutlookSurveyBasis,256,257–8Brands,293 346IndexBubblepremium,312–13Chain-priceindex,106Bubbles,296–313ChicagoBoardOptionsExchangeBudgetdeficit,51,148–55(CBOE),241Budgetsurplus,50ChicagoPurchasingManagersIndexBureauofEconomicAnalysis(BEA),(ChicagoPMI),16575–6,106,122,135,145,156Circularflowdiagram,3–4Burns,Arthur,88,234,315Clearingcorporations,261Bush,GeorgeW.,235Clinton,Bill,154Businesscycle,71–102Co-movement,72,90diffusionindexes,315Commodityprices,111–16IndexofLeadingIndicators,CommodityResearchBureau(CRB)121–3futuresindex,114,116inventories,146,148Commonstockvaluation,38–41investmentspending,138–9,141,Competition,204,240,286,287,146,148289,290turningpoints,75,89,90,123,Compoundinterest,33–4,42–4,141,148,225–945–6yieldcurves,225–9ConferenceBoardConsumerBusinessOutlookSurvey(BOS)ofConfidenceIndex,160,161–3thePhiladelphiaFed.,116,Constantgrowth,39168–9,315,316Constantprices,8Constructionspending,141–2,145ConsumerConfidenceIndex,160,161–3CAEMC,seeCentralAfricanConsumerPriceIndex(CPI),86,87,EconomicMonetaryCommunity113,115,116–18,320–2Calloptions,243,244,263,265,ConsumerSentimentIndex(ICS),267–72160–1,163Black-Scholesmodel,278Consumers:determinantsofvalue,275–77confidence/sentiment,77,80,put-callparity,275,277159–73Capacityutilization,78–9,110–11,expenditure,2,6–7,82,125–38,146,205,287,292173Capital:Consumption:assets,294–5borrowing,51deepening,281businesscycle,76fixed,14circularflowdiagram,4just-in-time,101interestrates,47–8mobility,179,180,181personalconsumptionCapitalism,289expenditure,127,135–6Carsales,77–8,126–8,133,137–8realGNP,6–7Cash:seealsodemandsavings,49–50Contraction,72,73–5,77,80–1,stock/bondvaluation,36,3888–90,91–5Cashandcarrytransaction,256,259diffusionindexes,315‘CastlesintheAir’theory,310householdincome,172CBOE,seeChicagoBoardOptionsindustrialproduction,109–10ExchangeNAPMindex,166CentralAfricanEconomicMonetaryunemployment,132Community(CAEMC),186,188seealsorecessionCentralBankAgreement,198,199Convergence,196,197,198Centralrateadjustments,199–200Conversionperiod,42,45 Index347Copyrights,293assetmarketapproach,212Costs:businesscycle,72,73–4,75,accounting,294–577–8,80–1,100basis,257–8capacityutilizationrate,110carry,254–5,256,258currencysubstitution,181labour,48,80,146domesticgoods,209production,48,79exchangerateregime,186CPE,seePersonalConsumerinventories,146ExpenditurePriceIndexloanablefunds,48,51,52,53,60CPI,seeConsumerPriceIndexmacroeconomicbalance,207Crawlingbands,191–2,195marketsegmentationtheory,66Crawlingpegs,191monetarypolicy,83CRBindex,seeCommoditymoney,10–11,14,23,48,85,ResearchBureaufuturesindex181Credibility,83,175–6,178–9,180non-acceleratingrateofCredit:unemployment,98businesscycle,73,74,77,82rising,2consumer,137–8securities,55monetarypolicy,84supplysideeconomics,151,153Creditrisk,245,260,261trianglemodel,291–2Crudeoilprices,93,111–13,157seealsoconsumptionCurrency:Demographics,98,100appreciation,204,208–9,Depreciation:213–14,216–17,218,219currency,204,209,217,218basis,257,258price,48,54businesscycle,71Depression,88,92–3crises,184–5Derivatives,240–83depreciation,204,209,217,218Deterministicarbitrage,246–7interestrates,72Developingcountries,175–6,178,peggedexchangerate,177179SpecialDrawingRights(SDRs),Diffusionindexes,91,123,157,177,189–90,191,194,195,166,315–17201Digitization,288substitution,179–82Disclosures,27–8swaps,242,243Discountrate,7,24,35,56,58seealsodollar;euro;exchangeDiscountWindowBorrowing,23,rates;foreignexchange24–5,230–1Currencyboards,176,186,188,Discounting,33,34–6194,195,201Disposableincome,3,4,5,91Currencyunions,186,187–8Diversification,101,180Currentaccountdeficit,207Dividends,38–40Currentprices,8Dollar:assetmarketapproach,210–12,213,214–15,216–21Debt:basis,257businesscycle,74–5carsales,128currencypegs,177ConsumerPriceIndex,117macroeconomicbalance,207demandfordomesticgoods,209SouthSeabubble,306Euro-Dollarfuturescontract,Demand:231–2aggregate,2–5,10–11,14–15,84,foreignexchange,163153GDPdeflator,107 348IndexDollar(cont.)EmploymentCostindex(ECI),housingstarts,141119–20IndexofLeadingIndicators,123EMS,seeEuropeanMonetarymanufacturingorders,145Systemmerchandisetradereport,87EMU,seeEuropeanEconomicandpeggedexchangerates,177MonetaryUnionpersonalincome,136Energyprices,107,111–13,117,producerpriceindex,108118,157,292productiondeclines,148Equilibrium:retailsales,134exchangerate,205,207,208tariffs/quotas,208interestrates,51tradedeficit,157moneysupply/demand,11unemploymentrate,132unbiasedexpectationstheory,Dollarization,179–8261–2DowJonesIndustrialIndex,309Equitymarket,297Durablegoods,78,86,135,143–5,ERMII,seeExchangeRate148,162MechanismEstablishmentsurvey,128,130–1Estrella,Arthur,227EastCaribbeanCommonMarketEulerequation,303(ECCM),186,187Euro,186,188,190,193–201ECB,seeEuropeanCentralBankassetmarketapproach,210–12,ECCM,seeEastCaribbean213,214–15,216–21CommonMarketbasis,257ECI,seeEmploymentCostindexEuro-Dollarfuturescontract,Edison,Thomas,282231–2Efficientmarkethypothesis(EMH),EuropeanCentralBank(ECB),8,300–2196,197–8,199–201Elasticityofdemand,52,181EuropeanEconomicandMonetaryElasticityofsupply,52Union(EMU),194–6Electricity,285EuropeanMonetarySystem(EMS),EMH,seeefficientmarket193,196,197,198hypothesisEuropeanoptions,244,262,263,Employment:267,275,278averagehourlyearnings,118–19EuropeanUnion(EU),194–201businesscycle,72,76,79,82Exchangerate,174–202construction,140assetmarketapproach,210–19consumerexpectations,171fixed,174–6,178,179,181,EmploymentCostindex,119–20182–5,191employmentreport,109,128–32currencyunions,186exchangerate,183interestrates,53Help-WantedAdvertisingIndex,flexible,174–5,176,177–8,180,169–71182–5,187indexofindustrialproduction,109floating,53,177,178,182–5monetarypolicy,84elasticityofdemand,181NAPMindex,164,166euro,194,195quitrate,132–3IMFcategories,186,187,192–3recession,91fundamentalapproach,203–9report,86monetarypolicy,84–5seealsolabourmarket;pegged,175,176–7,178–9,181unemployment;wages;euro,193–4,195workinghoursIMFcategories,185–7,189,190–1 Index349real,205–6,207expecteddemand,220reasonsforchange,215–19macroeconomicbalance,207seealsocurrency;foreignmonetarypolicy,84–5exchangespecialdrawingrights,190ExchangeRateMechanism(ERMII),Extrapolativeexpectations,299193,194–201Exchange-tradedoptions,244–5Exerciseprice,244,266,267–8,Federalfunds:269–73,274–6,277interestrates,223–4,226,227,Exogenousexpectations,298230–1,232,237–8Expansion,72–5,77–9,88–90,targets,18,19–22,23,24,25–7,91–5,100–1,10228capacityutilizationrate,111FederalOpenMarketCommitteeconsumerconfidence,163(FOMC),19–28,222,224–5,diffusionindexes,315229,232,236–8help-wantedadvertisingindex,FederalReserve:170averagehourlyearnings,119householdincome,172Congress,235housing,141discountrate,7industrialproduction,109–10easingofpolicy,6,85,131,145,NAPMindex,166168,236–8unemployment,132expansionarymonetarypolicy,seealsogrowth154Expectations,7,85,102Fedwatchers,222–4,229–30,bubbles,297,298–300,301–3233,234,239consumer,159,160,162,171–2fundamentalanalysis,85dollardepreciation,218–19highergrowthtargets,288Federalfunds,25indexofindustrialproduction,goldprices,249109monetarism,9interestrates,108rational,297,299,300,301–2monetarism,9,18–28short-terminterestrates,226,229monetarypolicy,84–5statisticalarbitrage,247–8moneysupplygrowth,5–6unbiasedexpectationstheory,non-acceleratingrateof59–62,64,65,68,70unemployment,96Expenditure:policychanges,232–3businesscycle,76,82retailsales,133–4consumer,2,6–7,82,125–38,173Financialassets,13–15government,2,3,51,76,148–55Fiscaldeficit,51circularflowdiagram,4Fiscalpolicy,9,149,150realGNP,6–7centralratestabilization,199saving,48exchangerate,175–6,178intangibleassets,293–4expansionary,151investment,2,4,6–7,138–48GNP,17Keynesiantheory,14householdincome,172monetarypolicy,84realinterestrates,226Expirationofoptions,266,267,seealsomonetarypolicy268–70,272–3,275,276Fixedcapital,14Exports,4,156–7Fixedexchangerates,174–6,178,aggregatedemand,2,3179,181,182–5,191assetmarketapproach,210,218currencyunions,186demandfordomesticgoods,209interestrates,53 350IndexFixedweightdeflator,106,107Foreigntrade,156–8Fixed-incomemarkets:Forwardcontracts,241–2,243,consumerindicators,125,127,245,259–60131,134,136advantages/disadvantages,262economicindicators,6,108,prices,251–3,254,258–9,260109–10,117,119Forward/forwardrate,231–2fundamentalanalysis,85,87Friedman,Milton,15,16,30–1investmentindicators,140–1,Futurevalues,33–4,41144,145Futures,241,242,243,245,254–6,NAPMindex,168260–2Fixed-incomesecurities,6,54advantages/disadvantages,262Flexibleexchangerates,174–5,basis,257–8176,177–8,180,182–5,187CommodityResearchBureauFloatingexchangerates,53,177,futuresindex,114178,182–5prices,231–2,251–3,254–6,elasticityofdemand,181257,259,260–1euro,194,195IMFcategories,186,187,192–3FOMC,seeFederalOpenMarketGarber,P.M.,305CommitteeGDP,seegrossdomesticproductFoodprices,107,111,113–14,117,GDPdeflator,105–7118,292Gillette,293Forecasting:Globalization,100,101,286,businesscycles,71,75,85–7287–8,289,290efficientmarkethypothesis,301,GNP,seegrossnationalproduct302GNPdeflator,6,318–20,321–2Fedwatchers,223Goldtrading,246,247,248–54,IndexofLeadingIndicators,258–9122–3Goldilockseconomy,94probabilitydistributions,248–51Gordongrowthmodel,39rationalexpectations,299Gordon,Robert,285,287,291stockprices,303Governmentspending,2,3,51,76,yieldcurves,225–9148–55Foreigndeposits,210–15,216–17,circularflowdiagram,4219realGNP,6–7Foreignexchange,174–202saving,48averagehourlyearnings,119GreatDepression,10consumerconfidence,163Greenspan,Alan,96,99,101–2,consumerindicators,125,127–8,182,286,296132,134,136indicators,120,124,133,163,168ConsumerPriceIndex,117interestrates,232,234economicactivity,72Grossdomesticproduct(GDP),8,fundamentalanalysis,85,87103–5GDPdeflator,107businesscycle,77,88,90–1,93,industrialproduction,11094investmentindicators,141,145,deflator,105–7148governmentspending,149monetarypolicy,83,84interestrates,223–4NAPMindex,168investmentspending,138–9producerpriceindex,108nominal,125,223–4seealsocurrency;exchangeratepersonalconsumerexpenditure,Foreigninvestment,50,53,105135–6 Index351real,8,88,90–1,93,94,98,99,IMF,seeInternationalMonetary223–4FundTaylorrule,233Implicitpricedeflator,106,107Grossnationalproduct(GNP),2,8,Impliedforwardinterestrate,103–568–70budgetdeficit,149–50,153–4Imports,4,156–7deflator,6,318–20,321–2aggregatedemand,2,3fiscalpolicy,17assetmarketapproach,210,218interestrates,223demandfordomesticgoods,209nominal,2,5–7,103,318–20expecteddemand,220real,6–7,9,227,319–21macroeconomicbalance,207recessions,81–2monetarypolicy,84–5residentialconstructionspending,prices,292141–2Income:tradedeficit,158borrowing,51Growth:businesscycle,72,73–4,77,78,commonstockvaluation,38–4180exchangerateregime,177disposable,3,4,5,91industrialproduction,109–10,national,3,4–5,11–12111netfactor,8,104–5investmentindicators,145nominal,319marketexpectations,226personal,135–6money,5–6,17,18,19–22,76quantitytheoryofmoney,13NAPMindex,167SindlingerHouseholdLiquidityneweconomicparadigm,281–5,Index,171–3288,289–0unequaldistribution,153nominalGNP,5,6seealsowagestotalfactorproductivity,284IndexofIndustrialProduction,seealsoexpansion109–10,111IndexofLeadingEconomicIndicators(LEI),75,121–3,161,Hardouvelis,G.A.,311,312167Hedging,254IndexofPricesReceivedbyFarmersHelp-WantedAdvertisingIndex,(AgPriceIndex),113–14169–71Indicators:Hoff,Ted,281,285consumerconfidence/sentiment,Hoover,J.Edgar,309160–73Householdsurvey,128,130–1consumerexpenditure,125–38Housing:economic,5–8,85,103–24constructionspending,141–2investment,138–48demandfor,77,82leading,75,121–3,161,167newhomesales,142–3Inertia,291prices,72Inflation:starts/permits,78,86,140–1averagehourlyearnings,119Humphrey-HawkinsTestimony,99,budgetdeficits,153–4102,223businesscycle,76,77,79,80,83,Hyperinflation,18193capacityutilizationrate,110–11ConsumerPriceIndex,117IBM,284,285core,107,117ICS,seeMichiganIndexofcrudeoilprices,112ConsumerSentimentdollarization,179,181 352IndexInflation(cont.)FederalReservetargets,21–3,24,exchangerate,175,176,177,25,26178–9,180,183fixedexchangerate,182,184Federalfundsrate,232fixedincomesecurities,6FederalReservetargets,19,22–3foreignexchange,72,141GDPdeflator,105–7forwardcontracts,241–2Germany,10forwardrate,58,59,61,67indexofindustrialproduction,function,47–8110impliedforwardrate,67,69–70inventories,146indexofindustrialproduction,macroeconomicbalance,205110marketexpectations,226,227interestparitycondition,212–13monetarism,9,17,18internationalfactors,50,51,53–4monetarypolicy,238inventories,147,148neweconomicparadigm,289,KeynesianTheory,14–15290monetarism,9nominalGNP,6monetarypolicy,84non-acceleratinginflationrateofnewhomesales,143unemployment,28–32,95–9,nominal,17,42,45–6,76,233286,287non-acceleratingrateofproducerpriceindex,107–8unemployment,96reports,87options,263,265,277supplysideeconomics,151producerpriceindex,108Taylorrule,233,234real,76,226trianglemodel,291–2reports,87seealsohyperinflation;pricesretailsales,134Information,301,303risk,262Informationtechnology(IT),281–4,risk-free,263,265,277288–9,290savings,50Intangibleassets,293–5shipments,145Intel,282,283,285short-term,23,67,84,226,227,Interest:231–2,233bondvaluation,36–7stockmarket,85compound,33–4,42–4,45–6swaps,242,243discounting,35termstructure,56–8,59,61–2,nationalincome,4–563–5,66–8simple,41,43velocity,15Interestparitycondition,212–13Internationalcompetitiveness,Interestrate,47–70,222–39204–5assetsubstitution,181InternationalMonetaryFund(IMF),assetyields,14185–90,201–2budgetdeficit,154Internationalization,240businesscycle,73,75,77–9,81,Internet,283,284,28682–3Intervention,199,200carsales,127Inventories,139,143,146–8ConsumerPriceIndex,117businesscycle,81–3determinationof,48–53,58investment,76,81–2,139,146–8dollar/eurodeposits,218,219just-in-time,100economicactivity,71NAPMindex,164,165,166–7effective,45–6Investment:employmentreport,131–2assetmarketapproach,211–12exchangerate,220bondvaluation,36–7 Index353bubbles,304–5,307–8,309,311,LEI,seeIndexofLeadingEconomic312Indicatorsbusinesscycle,72,73,76,83,90Liquidity:commonstockvaluation,38–41preferencetheory,59,62–5,66–7efficientmarkethypothesis,300premium,63,64,65expectations,226savings,49foreign,50,53,105Livingston,M.,267indicators,138–48Long-term:intangibleassets,293,294exchangeratedetermination,interestrates,47,53,232203–9inventory,76,81–2,139,146–8securities,62–3,66,226Keynes,296Lucas,RobertE.Jr.,72liquiditypreferencetheory,62–5macroeconomicbalance,206marketsegmentationtheory,66MacKay,C.,307,310–11moneysupply,16Macroeconomicsnetfactorincome,104–5cyclicalbehaviour,75preferredhabitattheory,66–70macroeconomicbalance,205–8spending,2,4,6–7,138–48nationalproduct,1–2unbiasedexpectationstheory,NewEconomy,7360–1standardmacroeconomicmodel,1IT,seeinformationtechnologyMalkiel,B.G.,310Manufacturing:BusinessOutlookSurvey,168–9JOCindex,seeJournalofdurablegoods,143–5Commerceindexinventoryinvestment,146–8JohnsonRedbook,134NAPMindex,166JournalofCommerce(JOC)index,ProducerPriceIndex,107115,116vendordeliveriesindex,124Just-in-timeinventories,100seealsoproductionMarketsegmentationtheory,59,66Martin,WilliamMcChesney,235Keynes,JohnMaynard,13,15,296,Meyer,Laurence,96297,303MichiganIndexofConsumerKeynesianTheory,13–15Sentiment(ICS),160–1,163Kilby,Jack,282,285Microprocessors,281–3,285Krugman,P.,182–5,287,289,290Microsoft,293Miller,G.William,234Miller,PaulE.,235Labourmarket:Mishkin,Frederick,227businesscycle,76Mitchell,Wesley,88,315exchangerate,178,180Modigliani,F.,31,32,286Help-WantedAdvertisingIndex,Monetarism,8–12,14,15–28169–71Monetarypolicy:seealsoemploymentBlindercritique,239Labourproductivity,76,77,79,80,businesscycle,77,82–5138centralratestabilization,199Laffercurve,152Europe,197,201Lawofoneprice,204exchangerate,178LeadingEconomicIndicators(LEI),expansionary,154,23075,121–3,161,167FederalReserve,18–28Lehman,M.B.,73,76FOMCdirectives,236 354IndexMonetarypolicy(cont.)Non-acceleratinginflationrateofGNP,17unemployment(NAIRU),28–32,householdincome,17295–9,286–7inflation,31,238Non-borrowedreserves,18,22–4,macroeconomiceffects,22525,230–1monetarism,9,18–28Non-residentialfixedinvestment,non-acceleratingrateof139,143–5unemployment,98,99Normaldistribution,249,250,251,realinterestrate,226278,279reserveavailability,226securities,230Taylorrule,233,234Oilprices,93,111–13,157seealsofiscalpolicyOpen-marketoperations,22,24,25,Monetization,153–426,27–8,229–30Money:Opennessofeconomy,174,178,180demand,10–11,14,23,48,85Optimalcurrencyareas,174,178,elasticityofdemand,181185fundamentalanalysis,85Optimism,102,137,163,183growth,5–6,17,18,19–22,76Options,241,242–5,251,262–83monetarism,8–12,14,15–28calloptions,243,244,263,265,quantitytheoryof,9–12,13,14,267–7215Black-Scholesmodel,278–9savings,49–50determinantsofvalue,275–77supply,11,15–16,18,26,52–3,put-callparity,275,27785,154,232putoptions,243,244,272–5,timevalueof,33–46277transmissionmechanism,12–15Orders,143–5,148,157,164,165,166Output:NAIRU,seenon-acceleratingbusinesscycle,73,79inflationrateofunemploymentdemand/inflationrelationship,Nakamura,L.,294291–2NationalAssociationofPurchasinggap,98Managers(NAPM)Pricesindex,interestrate,23286,116,124,157,164–8,169,macroeconomics,2316monetarism,16NationalBureauofEconomicmonetarypolicy,84Research(NBER),87–90,91neweconomicparadigm,289–90Nationalincome,3,4–5,11–12quantitytheoryofmoney,11,12,Nationalproduct,1–2,415seealsogrossnationalproductrealGNP,319NBER,seeNationalBureauofTaylorrule,233EconomicResearchtotalfactorproductivitygrowth,Netexports,3,4,7284Netfactorincome,8,104–5seealsogrossdomesticproduct;NewEconomicParadigm,73,100,production281–95Over-borrowing,73Newhomesales,142–3Over-expansion,74NominalGDP,125,223–4Over-the-counteroptions,244–5NominalGNP,2,5–7,103,318–20Overseasinterestrates,50,51,Nominalinterestrate,17,42,45–6,53–476,233Overvaluation,311,312 Index355Papademos,L.,31,32,286food,107,111,113–14,117,118,Paramount,293292Patents,293,294futures,231–2Peggedexchangerates,175,176–7,GDP,8,104178–9,181GDPdeflator,105–7euro,193–4,195GNPdeflator,318–20,321–2IMFcategories,185–7,189,import,292190–1interestrates,48,232Persistence,90Interneteffecton,286PersonalConsumerExpenditureinventories,147(CPE)PriceIndex,223KeynesianTheory,13–14Personalconsumptionexpenditurelawofoneprice,204(PCE),127,135–6monetarism,16,18Personalincome,135–6monetarypolicy,84Pessimism,137,163,182,183oil,93,111–13,157Pfizer,293producerpriceindex,107–8Phelps,E.S.,30–1productivity,209Philadelphia(Philly)index,116,quantitytheoryofmoney,9–12168–9,315,316reports,87Phillips,A.W.,30rising,16,18Phillipscurve,9,30,95–6,99spot,56–7Phillyindex,seePhiladelphiaindexforward/futurepricePolitics,176,235relationship,255–6,257,PPI,seeProducerPriceIndex258–9PPP,seePurchasingPowerParitygold,251–3,254‘pre-ins’,197,198,199,200oil,111–12Preferredhabitattheory,59,66–70stock,117,122Presentvalue,33,34–6,41,56–7,bubbles,296–31358businesscycle,72,76Price/earningsratio,293–5consumerindicators,132,134,Prices:136bubbles,296–313economicindicators,107,108,businesscycle,72,77,79,90117,122commodity,111–16efficientmarkethypothesis,constant,8,104301–2consumerpriceindex,320–2Eulerequation,303current,8,104investmentindicators,141derivatives:monetarypolicy,84arbitrage,245–8,253–4supplyshocks,99basis,257–8yieldrelationship,54–6forwardcontracts,241–2,seealsoinflation;value251–3,254,258–9,260Probabilitydistributions,248–51futures,251–3,254–6,257,ProducerPriceIndex(PPI),86,87,259,260–1107–8,113,115marketparticipants,251–3Production:options,242,243–4,245,251,businesscycle,72,73,74,76,262–8380probabilitydistributions,capacityutilization,78–9,248–51110–11,146,205,287,292energy,107,111–13,117,118,indexofindustrialproduction,157,292109–10,111exchangerate,220interestrates,48 356IndexProduction(cont.)housing,141inventories,146,147,148IndexofLeadingIndicators,122macroeconomicbalance,205investment,139NAPMindex,164,166NAPMindex,167producerpriceindex,107–8personalincome,136recession,91taxcuts,152report,86yieldcurves,225,227–8,229seealsogrossdomesticproduct;seealsocontraction;depressionmanufacturing;outputReplicatingportfolio,263–5,266–7Productivity,90,146,209,219,220Reports,85–7,105,106,148,165labour,76,77,79,80,138Researchanddevelopment(R&D),neweconomicparadigm,281–5,295287,288–90Residentialfixedinvestment,76,Profits:139,140–3arbitrage,246–8Retailsales,7,77–8,86,127,businesscycle,72133–4,137–8,148intangibleassets,293–5Rich,R.W.,290,292nationalincome,4–5Risk:options,270–2,273–5deterministicarbitrage,246PurchasingPowerParity(PPP),futures/forwards,262204–5,218interestrate,62–3Putoptions,243,244,272–5,277moneysavings,49Put-callparity,275,277preferredhabitattheory,66–7seealsocreditriskRisk-freeinterestrate,263,265,Quantitytheoryofmoney,9–12,13,27714,15Quitrate,132–3Quotas,208,218,220Samuelson,P.A.,30Savings,4,48–50,52,119,136,R&D,seeresearchanddevelopment206Rateofreturn:Schiller,Robert,312dollardeposits,210–21Scholes,Myron,241,242,278interestrates,47Schwarz,AnnaJacobson,16securities,49Screen-basedtrading,261valuation,36,38SDRs,seeSpecialDrawingRightsseealsoyieldSecurities:Rationalexpectations,297,299,calloptions,269–70,276300,301–2expectations,226Rationalspeculativebubblefixed-income,6,54hypothesis,312interestrates,47,50,52–3,54–6Recession,73,81–2,88,90–1,long-term,62–3,66,22693–4,101–2marketsegmentationtheory,66budgetdeficit,149,150monetarypolicy,230capacityutilizationrate,111preferredhabitattheory,67,carsales,12768–9,70constructionindustries,142prices,54–6consumerconfidence,159,163savings,49,50consumercredit,137short-term,62,66,226crudeoilprices,112–13yieldcurve,59help-wantedadvertisingindex,170Seigniorage,176,186 Index357Sensitivematerialsprices(SMPs),consumerconfidence,163115,116consumerindicators,125,127,Servicesector,124,135,167,290132,134,136Sharpe,W.F.,59ConsumerPriceIndex,117Shipments,143–5,148,157crudeoilprices,113Shocks:fundamentalanalysis,85,87exchangerate,175,180,181householdincome,172supply,99,290,291,292industrialproduction,110Short-term:investmentindicators,141,145,148assetmarketapproach,210–15NAPMindex,168ECBfinancing,200prices,122interestrates,23,67,84,226,producerpriceindex,108227,231–2,233tradedeficit,158monetarism,15Stocks:securities,62,66,226basis,257,258Simpleinterest,41,43Black-Scholesmodel,280SindlingerHouseholdLiquiditybusinesscycle,71Index,171–3IndexofLeadingIndicators,123SMPs,seesensitivematerialspricesprices,117,122Socialsecurity,5,120,135bubbles,296–313Solow,Robert,30,289businesscycle,72,76SouthSeabubble,302,305–8,310consumerindicators,132,134,SpecialDrawingRights(SDRs),177,136189–90,191,194,195,201economicindicators,107,108,Speculation:117,122bubbles,296–313,309–12efficientmarkethypothesis,crises,301301–2exchangerate,182,184–5,197Eulerequation,303goldprices,252investmentindicators,141SouthSeabubble,306,307monetarypolicy,84Speculativebubbletheory,309–12seealsocommonstockvaluationSpending,seeexpenditureStructuraldeficit,150,154Spillovereffects,100,282,283,Substitutability,13,15284–5Supernormalgrowth,39–41Spotinterestrate,56–7,58,59–65,Supplierdeliveries,164,16766,67–70seealsovendordeliveriesSpotmarkets,56,251,254,255Supply:Spotprices,56–7assetmarketapproach,212forward/futurepricerelationship,businesscycle,73–4255–6,257,258–9exchangerateregime,186gold,251–3,254loanablefunds,48–50,51–2,53,oil,111–1260Staiger,D.,287marketsegmentationtheory,66Standarddeviation,249,250–1,money,11,14–16,18,26,52–3,278,28085,154,232Standardmacroeconomicmodel,1securities,55Statisticalarbitrage,247–8shocks,99,290,291,292Stock,J.H.,287trianglemodel,295,296Stockmarket:Supplysideeconomics,150–31987crash,25,301–3Sustainability,205averagehourlyearnings,119Swaps,242,243bubbles,296–313Szymczak,M.S.,235 358IndexTargets,5,18–28,223–4,230,232,naturalrateof,17,30,31,96–8,238205Tariffs,208,218,220neweconomicparadigm,289–90Taxation:Non-AcceleratingInflationRateofdisposableincome,5(NAIRU),28–32,95–9,286–7governmentspending,149,150outputgrowth,292savings,48quitrate,132–3supplysideeconomics,151–3recession,91,93,94Taylor,John,233,234supplysideeconomics,151,152Taylorrule,233–4Unemploymentbenefits,5,86,120,Technology,98,100,240129,131globalization,287neweconomicparadigm,288spillovers,284–5Valuation:workerinsecurity,99,286bond,36–7seealsoinformationtechnologycommonstock,38–41Termstructure,56–8,59,61–2,seealsoovervaluation63–5,66–8,225–6Value:TexasInstruments,282,285bubbles,297–8,303Timevalueofmoney,33–46compounding,33–4,42–4Titanic(film),293discounting,34–6Totalfactorproductivitygrowth,future,33–4,41284present,33,34–6,41,56–7,58Trade,86,156–8,290seealsopricesassetmarketapproach,210Velocityofmoney,11–12,15exchangerate,174,178,180Vendordeliveriesindex,123–4tariffs/quotas,208seealsosupplierdeliveriesseealsoexports;globalization;Veryshort-termfinancing,200importsViagra,293Trademarks,293Volcker,Paul,9,22–3,234Transferpayments,3,5Transmissionmechanism,12–15Trianglemodel,291–2Wadhwani,S.,286Tulipmaniabubble,302,304–5,WAEMU,seeWestAfricanEconomic310andMonetaryUnionTurningpoints,75,89,90,123,Wages:141,148,225–9averagehourlyearnings,118–19Two-periodbinomialmodel,265–7businesscycle,76ConsumerPriceIndex,117nationalincome,4–5Unbiasedexpectationstheory,nominal,3059–62,64,65,68,70non-acceleratingrateofUncertainty,24,83unemployment,95Unemployment:rising,16,18businesscycle,72,76,77technologyeffecton,99employmentreport,128–32unemploymentrelationship,30–1Help-WantedIndex,170workerinsecurity,286interestrate,232seealsoincomemacroeconomicbalance,205,WallStreetCrash,309207Watson,M.W.,287monetarism,9,17Wealth,72,84monetarypolicy,238WestAfricanEconomicand Index359MonetaryUnion(WAEMU),186,businesscycle,77,78,79,80,18881,225–9Workinghours,128–9,131,170interestrate,59,60–1,64–5,68–70seealsorateofreturnYieldpreferredhabitattheory,66–70pricerelationship,54–6Zerogrowth,38–9yieldcurves: