Financial Environment: FN6411

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• Financial Environment FN6411
• Summer 2004
• Sris Chatterjee

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From WSJ, 30 April 2004
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The Financial Environment

• Interest Rates
• Inflation
• Stock and Bond Returns
• Volatility
• Currency Exchange Rates
• Investors

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Questions

• What does Mr. Greenspan cut when he is
  cutting rates ?
• And how does he cut it ?
• What is the discount rate ?

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Questions

• What is the yield to maturity or YTM ?
• What is coupon yield ?
• What do bond ratings signify ?
• How does inflation affect the rates ?
• What factors are important ?

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Theoretical Yield-Curve Movements
Source Roll, Empirical TIPS Financial
Analysts Journal, Jan/Feb 2004 P. 39
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Theories of Term Structure

• Pure Expectations Theory
• Liquidity Theory
• Preferred Habitat Theory
• Market Segmentation Theory

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Nominal and Inflation-Adjusted Annualized Monthly
Geometric Mean Returns for Stocks and- Bonds,
1871-2000
Source Jones and Wilson,The Changing Nature of
Stock and Bond Volatility, Financial Analysts
Journal, Jan/Feb 2004 P. 102
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Geometric and Logarithmic Means and Standard
Deviations for Nominal and Inflation-Adjusted
Stock and Bond Annual Returns, 1871-2000
Source Jones and Wilson,The Changing Nature of
Stock and Bond Volatility, Financial Analysts
Journal, Jan/Feb 2004 P. 106
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Variances, Covariances, and Correlations for
Nominal and Inflation-Adjusted Stock and Bond
Annual Returns, 1871-2000
Source Jones and Wilson,The Changing Nature of
Stock and Bond Volatility, Financial Analysts
Journal, Jan/Feb 2004 P. 107
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Nominal and Inflation-Adjusted Compound Returns
and Standard Deviations for Various Portfolios of
Stocks and Bonds, 1871-2000
Source Jones and Wilson,The Changing Nature of
Stock and Bond Volatility, Financial Analysts
Journal, Jan/Feb 2004 P. 107
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Returns, Risk, and Past Performance for Value and
Glamour Portfolios, May 1968-April 1990
Source Chan and Lakonishok, Value and Growth
Investing Review and Update Financial Analysts
Journal, Jan/Feb 2004 P. 77
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Descriptive Statistics for Indexed and Nonindexed
Bond Returns
Source Kothari and Shanken, Asset Allocation
with Inflation-Protected Bonds Financial
Analysts Journal, Jan/Feb 2004 P. 59
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Correlation between Real and Nominal Stock and
Bond Returns
Source Kothari and Shanken, Asset Allocation
with Inflation-Protected Bonds Financial
Analysts Journal, Jan/Feb 2004 P. 62
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Optimal Portfolios of Indexed Bonds, Nonindexed
Bonds, and Stocks Based on Nominal Monthly
Returns, 1997-2003
Source Kothari and Shanken, Asset Allocation
with Inflation-Protected Bonds Financial
Analysts Journal, Jan/Feb 2004 P. 67
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Daily Returns Means and Standard Deviations
Source Roll, Empirical TIPS Financial
Analysts Journal, Jan/Feb 2004 P. 33
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Efficient Frontier with Two TIPS, Two (Nominal)
T-Bonds, and the CRSP Value-Weighted Index
Source Roll, Empirical TIPS Financial
Analysts Journal, Jan/Feb 2004 P. 49
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Flow of Goods and Services ? The net exports of
any country are the value of a countrys exports
minus the value of its imports. ? Net exports
are also known as the trade balance. ? If net
exports are negative, then we talk about a trade
deficit. ? If net exports are positive, then we
talk about a trade surplus. ? In the case of the
value of imports being equal to the value of
exports, we say that a country has balanced
trade. Flow of Capital ? Net foreign
investment refers to the purchase of foreign
assets by do-mestic residents minus the purchase
of domestic assets by foreigners. Net foreign
investment (NFI) must always equal net exports
(NX) NFI NX
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? A nations savings and investment are related
to the international flow of goods and services,
and of capital. This can be shown formally as
follows ? Net exports (NX) can be found in the
components of Gross Domestic Product (GDP) Y
C I G (X M), where X is the value of
goods exported and M is the value of goods
imported. In other words, (XM) is equal to net
exports (NX). ? Re-arranged, this equation can
be written as Y C G I NX ? As national
savings (S) are equal to the national income that
is left after consumption (C) and government
expenditure (G), we can also write the
following S I NX (or S I NX) ? We
know that net exports are equal to net foreign
investment. Therefore S I NFI
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? The equation S I NFI shows us that a
nations savings must equal its domestic
investment plus its net foreign investment. In
other words, when Spanish citizens, for instance,
save one Euro of their income for the future,
this money can be used to finance Spanish
investments (I) or it can be used to finance the
purchase of capital abroad (NFI). ? We can also
use the saving-investment equation to explain the
fallacy of a trade deficit being a sign of a lack
of competitiveness. Looking at the equation S I
NX, we can state that a trade deficit (NX then
being negative) is not a problem in itself but is
more a symptom of a problem, namely low national
savings. ? To be more explicit, the reason for
trade deficits lie in the extent to which
national savings are not able to cover domestic
investments.
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Purchasing Power Parity How Good is the
Data? ? The Economist conducts a yearly analysis
of PPP. It is known as the Big Mac index and
compares the price of Big Macs, with each local
price being converted to US dollars. ? If PPP
holds, then the converted US dollar price should
be the same as the price that exists in the US.
? The table, using data from July 2001 taken
from the website http//www.oanda.com/products/
bigmac/bigmac.shtml, shows that PPP does not
always hold. In this case, we talk of either an
overvaluation or an undervaluation. ? For
Switzerland, this index shows that a Big Mac
costs 41 more in dollar terms in Switzerland
than it does in the US. Hence, the Swiss franc is
said to be overvalued by 41.
data from http//www.oanda.com/products/bigmac/big
mac.shtml, July 2001 Purchasing Power Price
local price divided by price in United States.
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Purchasing Power Parity and the EURCHF Rate
2.1
2.0
EURCHF
PPP EURCHF
1.9
1.8
1.7
1.6
1.5
1.4
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
Source Warburg Economic Research Switzerland