EXPECTATIONS AND

THE BOND MARKET

 $%&!"#
• The sum of a series 1+ x + 𝑥! + 𝑥" + …… + 𝑥# is
$%&
$
• The sum of a series 1+ x + 𝑥 ! + 𝑥 " + …… ∞ is (if x < 1).
$%&

• Present value: method to evaluate a sum of money to be paid out in the future.
• If you are to receive Rs X one year from now, assuming an interest rate i%, what sum of
money paid out today is equivalent to Rs X a year from now?
'
• Present value PV = . (Because if I invest sum of money PV today, in one year it will be
$()
'
PV(1+i), and it will be equivalent to X if PV(1+i)=X => PV = )
$()
 $
• is the discount factor. Transforms an amount of money coming due in the future to an
$()
equivalent sum today.
• The present value of a series of payments Z coming due at the beginning of every year –
starting with a payment Z today – for n periods, and assuming the interest rate is
constant at i% is:
* * *
• Present value = Z + + + …… +
$() ($())$ ($())%&#

• Z comes today. Next payment, at beginning of period 2. Next payment at beginning of

period 3. Final payment at beginning of period n.
 *
• PV of payment Z that is paid at beginning of period 2/end of period 1:
$()

*
• PV of payment Z that is paid at beginning of period 3/end of period 2 :
($())$

• PV of this stream of payments = PV of each individual payment.

$ $ $
• Present value = Z.[ 1 + + + …… + ].
$() ($())$ ($())%&#

• From the formula of sum of a geometric series:

$%(#- #"' % )
• Present value = z.[ ].
$%(#-#"')
• Present value of a series of payment made over an infinite period (assuming first payment
of Z made at beginning of second year, not now):
* *
• PV = + + …… ∞
$() ($())$
* $ $
• PV = .[1+ + + …… ∞].
$() $() ($())$
* $
• From formula of sum of infinite geometric series: PV = .[ # ]
$() $%( -#"')

*
• => PV = . PV is positively related to payments Z, negatively related to interest rate i%.
)
./0)123 56
• In real terms, Real(PV) = (See appendix to chapter 14 for proof).
57)89 39:93
THE BOND MARKET

• A bond is a financial instrument that promises to pay the holder of the instrument a fixed
sum of money in the future, or regular payments. The price of a bond is therefore the
present value of the future payment.
• Earlier, bearer bonds were bonds where the holder of the bond (or “bearer”) was eligible
to collect the payment. They were unregistered, meaning no records were kept of
ownership, or different transactions. Whoever held the bond was presumed owner.
• Plot point in many famous films. In two of the GREATEST films ever made (there will be
no discussion on this), Die Hard and Heat, the heists involved heists of bearer bonds.
• Owing to anonymity, used for criminal activities and tax evasion. Bearer bonds now illegal,
only registered bonds allowed. Now, bonds have to be registered. Used by governments
to raise money, engage in monetary policy operations.
• It is, essentially, a form of loan taken on by governments, and a valuable asset for
individuals to hold. Because governments have extensive power to raise resources
(ultimately, through taxation), govt bonds are seen as being very safe.
• Pension funds etc keep government bonds with them because they are a safe asset.
Financial crises (like the one in UK currently) affect pension funds and investment
portfolios through their effects on bond values.
IMPORTANT TERMS

• Maturity: Length of time over which bond makes payments to holder of bonds. Can be
low (<1 year, 1 year) to longer periods (+10 years).
• If single payment made when bond matures (at maturity) called face value of the bond. If
multiple payments made, called coupon payments.
• Price: what is to be paid today to purchase the bond.
• Yields: Returns to be got when one holds the bond (which we shall derive explicitly
now).
• A bond which give 20 yearly payments of Rs 100 and final payment of Rs 1000 has
maturity of 20, coupon payments of Rs 100 and face value of Rs 1000.
BOND PRICES AND BOND YIELDS

• Price of the bond is the present value of a bond. Consider a bond which gives Rs 100
$;;
after one year. With an annual interest rate i%, the price becomes P = .
$()

• If bond gives Rs 100 two years from now, and the interest rate for the second year is
$;;
unknown, the price is P = ( where 𝑖 9 represents our expectations of what the
$() .($() )
interest rate will be.
• This is an equilibrium condition. Will the market work to give this outcome? i.e. will
individual action by rational self-interested individuals bring this about?
ARBITRAGE

• Imagine you have a choice between holding bonds of maturity 1 year and two year, and
you are only worried about how much money you will have 1 year from now.
• If you invest Rs 1 in a one year bond, you will get a return of (1+i) (where i is the known
interest rate over one year.)
• Let price of a two year bond today be 𝑃!# . If you put one rupee in a 2 year bond today,
you will have ($'5$ ) bonds next year.
9
• Next year, the two year bond you hold will be a one-year bond. Let 𝑃$(#($) be the
expected price of a one year bond next period. That is, if you buy a two year bond today in
9
the hope of selling it next year, you will get 𝑃$(#($) next year. The person who buys this
bond from you will get Rs 100 (face value) at the end of year 2.
 &
!!(#$!)
• Your expected one-year return from holding a two-year bond is: . In equilibrium, where
!'#
you are indifferent between holding a one-year bond for one year or a two-year bond for one
&
!!(#$!)
year, the returns should be the same, i.e. (1+ i) = .
!'#
&
!!(#$!)
• => 𝑃"# = (%&')
)
• Now what is 𝑃%(#&%) ? It is the present value of a bond that offers Rs 100 at the end of the
second year at an interest rate 𝑖 ) .
)
• 𝑃%(#&%) is the present value from end of second year to end of first year of a payment of Rs
100 at a future interest rate.
 9 $;;
• i.e. 𝑃$(#($) = . From the arbitrage condition, we have:
($() ( )

$;;
• 𝑃!# = . Similar to the present value condition we sketched out earlier.
($())($() ( )

• In a market with rational individuals, the arbitrage condition will ensure that prices of
bonds will equal their present values (ideally!).
FROM BOND PRICES TO BOND YIELDS

• Yield to maturity on an n-year bond, or n-year interest rate, is that interest rate that
makes today’s price equal to present value of future payments of a bond.
• The process works like this: Government wishes to raise some money. They sell a bond
with 2-year maturity and face value of Rs 100 in the market. Suppose the market pays Rs
90 for this bond. Govt collects Rs 90 today, has to pay Rs 100 in two years. What is the
yield till maturity for the holder of the bond?
$;;
• The yield to maturity is calculated by 90 = => i = 5.4%.
($())$

• Basically, if I pay Rs 90 today and hold it for 2 years, I will get a return of 5.4% per year.
• This assumes a constant interest rate. What if interest rate in the second year is
unknown?
• The yield is interest on a 2 year bond from today to the end of two years. This is 𝑖!# .
• Let one-year interest rate from today to end of first year be 𝑖$# . This is known.
9
• Let expected one-year interest rate in the second year be 𝑖$(#($) . This is the interest rate
expected to prevail from end of first year to end of second year, a period of one year.
$;; $;;
• If price = present value, then = .
($()$! )$ $()#! .($()#( !"# )

• => (1 + 𝑖!# )! = 1 + 𝑖$# . (1 + 𝑖$9 #($ )

• Can be approximated to say 𝑖!# = ½.(𝑖$# + 𝑖$9 #($ ).
• The yield to maturity on bonds is an approximate averaging out of current interest rates
and our expectations of what future interest rates will be.
• When bond traders buy government bonds in the market, they are doing so based on
what they expect interest rates over the maturity period to be.
• If we change our expectations of what the future interest rate will be, it will affect the
price we pay today.
• The yields are inversely proportional to price. If yields rising, prices falling, and vice versa.
• So if interest rates expected to rise, what would happen to price of bonds?
INTRODUCING RISK

• Big risk of holding bonds is that the issuing authority – government or a company – will
not pay back. Risk profiles can vary.
• Government bonds generally seen as safe compared to companies, because govts can
always raise resources through taxation. Some countries seen as safer than others.
• Bonds with very high risk are called junk bonds. Rating agencies like Moody’s in charge of
evaluating risk profiles of bonds. (But huge criticism of their actions during 2008 financial
crisis. Watch this scene from the Big Short).
• Returns from holding bonds: ability to sell them later. Risk: that there will exist a market
for them, that sellers want to purchase it.
• Thus all investors want a risk premium x to hold a bond. The price of a one-year bond is
known, and no risk is involved. Risk is involved for bonds held over a longer period.
%**
• Thus price of a two year bond today with face value Rs 100 is: .
%&'!# .(%&'!& #$! &,)

• The risk premium involved because I need a premium over and above the interest rate to
hold a bond, since many things can happen in the future.
%** %**
• Thus the yield 𝑖"# : (%&' )'
= %&'!# .(%&'!& &,)
'# #$!

• => 𝑖"# = ½.(𝑖%# + 𝑖%) #&% + x).

• If interest rates expected to rise, what happens to price of bonds? If risk rises?
THE YIELD CURVE

• There is a risk in holding long-term bonds, because there can be changes to the interest
rate in the future, other forms of risk. So yields of long-term bonds will involve a risk
premium. Investors need a higher return to hold bonds for long periods, to be
compensated for risks.
• Yields therefore depend on expectations of interest rates in the future, and a premium to
hold longer-term bonds. Relation of yields over different maturity periods is called the
yield curve.
• Generally, because of risk premium, the yield curve is upwards sloping.
• Why would a yield curve slope downwards? Because investors would expect short-term
interest rate to be higher than long-term rates. Why?
• Because investors expect growth to slow down, so expect Central Bank to reduce
interest rates in the future, leading to lower long-term rates than short-term ones.
• A downward sloping yield curve is called an “inverted” yield curve, and indicates high
probability of a recession.
EXPLAINING THE UK CRISIS THAT PUT RISHI
SUNAK IN POWER
• Kwasi Kwarteng announces tax cuts. It is a surprise announcement, markets had no idea
it was forthcoming.
• As a result of the tax cut, what would markets expect would happen with economic
activity and inflation? What would they expect to happen to interest rates?
• Based on their expectations of what would happen to interest rates, what would happen
to yields? And hence what would happen to prices of bonds?
• Pension funds buy bonds because it is safe. Sell it to raise money to pay pensions. When
price of bonds fell (because yields rose because interest rates expected to rise
because…) they suffered significantly, since bonds form large part of their portfolio.
THE STOCK MARKET

• Bonds are examples of debt instruments. The issuer of the bond has essentially taken out
a loan, and has to pay back the face value (and coupon payments) at regular intervals of
time.
• Stocks are equities. The holder of shares in a company doesn’t get regular payments, but
gets a share in the profits.
• Holders of bonds get coupon payments, holders of equities get dividends. No maturity on
shares, can hold for however long.
RETURNS ON STOCKS

• If you hold bonds for one year, return you get is (1 + 𝑖$# ) where 𝑖$# is the one-year
interest rate at time t (i.e. today).
• Assume price of a stock today is 𝑄# . This is what I have to pay to buy a stock today. What
is return next year from holding stock?
• I expect to get a dividend next year (which may vary, depending on the company’s
9 9
performance) 𝐷#($ . I can also sell my stock next year at an expected price 𝑄#($ .
• There is a risk holding stocks, because price fluctuations are high. I want a greater return
from holding stock. Call this the equity premium x (not to be confused with risk
premium discussed earlier.)
ARBITRAGE CONDITION

• Thus my return from buying stock this year and selling next year is:
( (
=!"# (>!"#
• .
>!

• The return from holding bonds for one year is (1 + 𝑖$# ). Because of risk, I want a
premium x over and above the bond return. This is the equity premium.
• Equity premium explains why equity gives higher returns than bonds over long periods.
Because of risk, investors need to be compensated for it.
( (>(
=!"# !"#
• Arbitrage condition: = (1 + 𝑖$# + x).
>!
• Rewriting to get expression for price of a stock:
( (
=!"# . >!"#
• 𝑄# = +
(1 + )#! + x) (1 + )#! + x)
• Current price depends on expected dividends and expected future price. What does
expected future price depend on?
( .
=!"$ (
>!"$
9
• 𝑄#($ = +
(1 +)#!"#
( + x) (1 +)#!"#
( + x)
• Expected future price depends on future dividends and expected price in period t+2,
discounted by expected one-year interest rates in future period.
 9
• Putting expression of 𝑄#($ in expression of 𝑄# :
( ( (
=!"# . =!"$ >!"$
• 𝑄# = + +
(1 + )#! + x) (1 + )#! + x)(1 +)#!"#
( + x) (1 + )#! + x)(1 +)#!"#
( + x)
• If we expand this process to n years:
• Assume interest rates expected to be constant at i. Then the final term in previous
expression becomes:

• Assume people expect final price to converge to some value 𝑄/ in the future. Then the
>?
final term becomes: . As n becomes very large, this goes to zero (for a fixed 𝑄/ )
($()(&)%
• So therefore the price of a stock is:
( ( (
=!"# =!"$ =!"%
• 𝑄# = + +… …
(1 + )#! + x) (1 + )#! + x)(1 +)#!"#
( + x) (1 + )#! + x)...(1 +)#!"%&#
( + x)
( (
=!"# =!"$
• In real terms: 𝑄# = + +…
(1 + 7#! + x) (1 + 7#! + x)(1 +7#!"#
( + x)
• Price of a stock positively related to expected future dividends.
• Higher current and expected real interest rates reduce stock prices.
• Higher equity premium leads to lower stock prices.
INTEREST RATE REDUCTION AND STOCK MARKET
PRICES
• If Central Bank (CB) reduces interest rates, output
increases, and hence dividends.

• If reduction unexpected, stock prices will rise.

• Stock prices may not rise if market anticipated it, worked in

changed expectations of dividends and interest rates in
price calculations.

• Stock prices may reduce if market believes CB reducing

interest rates because economy slowing down.

• Clear communication by CB therefore very important.

INCREASE IN CONSUMPTION AND STOCK PRICES

• Assume consumption demand rises, IS shifts right. Economy moves from A

to A`. Output and dividends rise.
• Stock prices won’t necessarily rise, because market looks at actions of CB.
• If market doesn’t expect CB to act, then stock prices will rise. If market
expects CB to act following rising inflation, and for interest rates to rise to
r`, then will factor in higher expected real rates.
• If market doesn’t expect CB to act, prices will rise. But if CB then decides
to act, prices will fall. Volatility can be avoided based not just on CB’s
actions, but credible expectations that CB will act when inflation rises.
• Effects on stock prices depends on market’s expectations of future, and
expectations of CB action. Clear communication of CB’s inflation targets etc
therefore very important.
WHY DO STOCK MARKET “BUBBLES” HAPPEN?

• A financial market “bubble”: A situation where prices keep rising extremely rapidly, out of
touch with fundamental values, only for it to burst at some time and lead to crashing
prices.
• Fundamentals: expected level of dividends and real interest rates in the future, based on
proper analysis of earning capability of firm, future trends of interest rates and inflation.
• Problem: if market is efficient, and if information available to all, why do bubbles keep
occurring? Why do prices rise so high compared to fundamentals, and why do such large
crashes occur?
 US HOUSING PRICE-
TO-RENT RATIO
If a house is an asset, rents are like dividends
received from holding the asset.
Higher price-to-rent ratio means investors paying
extremely high price relative to the rents. Seen
during US financial crisis, where ratio rose, and
then crashed.
Optimists: rising ratio in all countries, good reason
to believe continuous rise would happen. Bubbles
easy to see in retrospect, not when it is happening.
REASONS FOR ASSET BUBBLES

• Asset bubbles occur when mispricing occurs, when market values assets out of line with
fundamental values. Seen constantly in history, from Dutch Tulip crisis in 17th century, to
“lost decade” of 90s and early 2000s in Japan to US sub-prime crisis.
• (Read Charles Kindleberger “Manias, Panics and Crashes” for a great history of financial
panics throughout history.)
• Why does mispricing occur in efficient markets with access to arbitrage?
• The theory of “rational speculative bubbles”. Even if a stock is worthless (imagine all
future dividends are 0), investors will buy it if they expect someone else to want it at a
later date.
• Even if stock worthless, will still be purchased if I expect someone in future to buy it. So
if investor is rational – i.e. interested in maximizing own gain – will purchase it in hope of
future sales. If everyone does so, prices will rise.
• Even if stock has some worth, but price >> fundamental values (i.e. over-priced), will still
buy it if I expect price to rise even further in the future.
• Even if stock has some worth, but prices crashing, and price << fundamental values, will
sell if I expect everyone else to sell. This can cause the bursting of a bubble, crash in
prices of stock of worthy companies also.
• Keynes: financial markets based not on fundamentals of companies, but on market
participants’ expectations of what others will do (the Beauty Contest example).
• Problem in real economy when panic in financial markets spreads to real markets. Stock
prices fall -> Companies failing -> Banks’ investment portfolios failing -> reduced lending
by banks -> reduced investment -> unemployment.
• Similarly, if rising financial asset prices driven by speculative optimism, can lead to over-
investment in real economy, rising inflation.
• Keynes has a much more pessimistic view of expectations than modern textbook
economics.
• Textbook macro: market participants still, by and large, pay attention to fundamentals, and
clear communication and credible action from CB can lead to stable equilibrium.
• Keynes: Modern capitalism is fundamentally speculative. Even if CB were to act credibly
and responsibly, will still have crises because of fundamentally speculative nature of
modern financial markets (for example the Great Financial Crisis of 2008).
• Famous quote: “When the capital development of a country becomes a by-product of a
casino, the job is likely to be ill-done”.