CH14: Financial Markets and Expectations

What is the expected present discounted value (EPDV)?

The value today of a sequence of future payments, discounted by the appropriate interest rates.

What is the formula for the present value of a future cash flow?

PV= CF_t+j / (1+i)^j

How does a higher interest rate affect the present value?

It lowers the present value of future cash flows

What is the key assumption behind EPDV?

Future interest rates and cash flows are known or can be reasonably expected

What determines bond price?

Present value of all future payments (coupons and face value), discounted at the interest rate

What is a zero-coupon bond?

A bond that pays no coupons and is sold at a discount, paying the face value at maturity

What does an upward-sloping yield curve indicate?

Markets expect higher interest rates in the future

What is the Expectations Hypothesis?

Long-term interest rates are averages of current and expected future short-term interest rates

How is the 2-year interest rate calculated if 1-year rates today and expected next year are known?

(1+i_2t)²= (1+i_1t)(1+i^e_1t+1)

What are the components of stock return?

Dividends and capital gains

What is the Dividend Discount Model (DDM)?

A stock’s value is the present value of expected future dividends

What happens to stock prices when interest rates rise?

Stock prices tend to fall due to higher discounting of future cash flows

What effect does an equity premium have on stock price?

A higher equity premium reduces the stock price

Why are stock prices volatile?

They react to expectations about future growth, profits, and interest rates

What is a fundamental value?

The present value of expected future dividends from a stock

What is a rational speculative bubble?

Stock prices rise because investors expect them to keep rising, not due to fundamentals

What is a fad in asset pricing?

When prices rise simply because they have risen in the past, with no underlying justification

What does the price-to-rent ratio in housing signal?

Whether housing prices are over- or undervalued relative to rental income