The document discusses key concepts related to stocks, bonds, interest rates, and their interrelationships. It provides examples of how changes in interest rates can affect bond and stock prices. Lower interest rates will increase bond prices and stock prices, while higher rates will decrease prices. The expectations theory holds that the long-term interest rate should equal the geometric average of the current short-term rate and expected future short-term rates over the term.

2. Money, Banking,
and Business
Lecture 14
Market Efficiency and
the Flow of Funds
Chapter 7

3. Questions?

4. Stocks
Bonds

5. Cash Flows Bond Stock
Return on Coupon Dividends
Return of Maturity Resale
Certainty Explicit Implicit
Risk Adj. Rate r r ++

6. Stocks
What determines the price?
Every transaction can set a
new price
Two incomes:
Dividends and Resale

7. Dividend
Resale - Capital Gain (Loss)
Yield
Price Today

8. Dividend $10
Capital Gain $100
Price $1,000
Yield Rate?
= 0.11 or 11%
$1,000
$110

9. Bonds
FaceValue does not
change
Coupon does not change
Market rates change
Issuer conditions change
Price changes with
market and issuer

10. Pooley Pizza Company
Bond
$1,000
Dollars
6% 2048
Pays $60 each year
Pays $1,000 at maturity

11. PV of 29 payments of
$60 at 4.0%
$1,019.02
PV of 1 payment of
$1,000 at 4.0% in 30 years
$320.65
$1,339.67

12. At then end of first year
$60 + $1,339.67
$1,399.67
$1,000
$339.69
39.69% gain

13. At then end of first year
$60 + $1,339.67
$1,399.67
$1,000
$339.69
39.69% gain

14. Why changes in
interest rates can
change bond and
stock prices

15. Bond Stock
Price $100 $100
Coupon - Div $6 $8
Rate 6% 8%
Rate Decrease 4% 6%
New Price $150 $133
New Div $10
New Price $167

16. Bond Stock
Price $100 $100
Coupon - Div $4 $6
Rate 4% 6%
Rate Increase 6% 8%
New Price $67 $75
New Div $5
New Price $63

18. 0%
50%
100%
150%
200%
250%
300% 1/1/00
6/1/00
11/1/00
4/1/01
9/1/01
2/1/02
7/1/02
12/1/02
5/1/03
10/1/03
3/1/04
8/1/04
1/1/05
6/1/05
11/1/05
4/1/06
9/1/06
2/1/07
7/1/07
12/1/07
5/1/08
10/1/08
3/1/09
8/1/09
1/1/10
6/1/10
11/1/10
4/1/11
9/1/11
2/1/12
7/1/12
12/1/12
5/1/13
10/1/13
3/1/14
8/1/14
1/1/15
6/1/15
11/1/15
4/1/16
9/1/16
2/1/17
7/1/17
12/1/17
FED Rate DJIA
1/1/2000
Fed Rate: 5.45%
DJIA: 10,940
1/1/2018
Fed Rate: 1.42%
DJIA: 26,149

19. -80%
-60%
-40%
-20%
0%
20%
40%
60%
80%
100%
120%
-100% -50% 0% 50% 100% 150% 200% 250%
%∆ Value
%∆ Rate
%∆ Value = 1 - (1÷(1+X))
%∆ Rate %∆ Value
X Y
-90.00% 900.00%
-80.00% 400.00%
-70.00% 233.33%
-60.00% 150.00%
-50.00% 100.00%
-40.00% 66.67%
-30.00% 42.86%
-20.00% 25.00%
-10.00% 11.11%
0.00% 0.00%
10.00% -9.09%
20.00% -16.67%
30.00% -23.08%
40.00% -28.57%
50.00% -33.33%
60.00% -37.50%
70.00% -41.18%
80.00% -44.44%
90.00% -47.37%
100.00% -50.00%
110.00% -52.38%
120.00% -54.55%
130.00% -56.52%
140.00% -58.33%
150.00% -60.00%
160.00% -61.54%
170.00% -62.96%
180.00% -64.29%
190.00% -65.52%
200.00% -66.67%

20. Expectations Theory
Should I buy a series of
short term security
or
one long term security?

21. Expectations Theory
The long term rate should
be equal to the geometric
average of the the current
short rate and the expected
short rates over the term

22. i1 = current short rate
i1 = expected short rate
i2 = current long rate
i2 = [(1+i1)(1+i1)] -1
i2 = √(1+i1)(1+i1) -1
e
e 1/2
e

23. i1 = 5%
i1 = 8%
i2 = ?
i2 = [(1+i1)(1+i1)] -1
i2 = √(1+i1)(1+i1) -1
e
e 1/2
e

24. i1 = 5%
i1 = ?
i2 = 4%
i2 = [(1+i1)(1+i1)] -1
i2 = √(1+i1)(1+i1) -1
e
e 1/2
e