In finance, we value investments (including stocks and bonds) based on their expected future cash flows, which we then discount “at the appropriate (required) rate”. Think about the basic equation for present value: PV = FV/(1 + r) where PV is the present value, or expected price we would pay for an investment, FV is the future cash flow and “r” is the required rate of return for the investment. Each expected future cash flow is discounted for the appropriate number of years. As we have seen in Module 3 so far, interest rates are driven heavily by inflation.
From this, it is easy to see why if the interest rate increases, the PV, or expected price is expected to decrease. The important thing to note here is “expected future cash flows”. When we say (see lecture notes and practice problems) that “interest rates have risen, what is the effect on prices?” the underlying assumption is that THE ONLY THING THAT HAS CHANGED IS THE INTEREST RATE, this is why we always stick to the assumption “all else equal”. What is meant is that for practice problems and for EXAMS, keep to the basics, don’t assume anything other than the indicated change has (or will) occur.
THIS WEEK’S DISCUSSION:
In recent weeks you may well have seen articles in the business press that seem to conflict with our underlying assumption above. “The market” looks at the bigger picture, factoring in not only inflation expectations and the effect on interest rates, but on other market forces, such as consumer attitudes, forecast economic recovery, etc. The market does not use the assumption “all else equal”!
For this week there are two different articles that will form the basis of the discussion, start with the article from the Associated Press, “Bond and stock prices fall on higher interest (inflation) rates”, it provides a basic overview of the price and return (yield) relationships. Next, read the article from Yahoo Finance “Stocks rise on higher interest rates”.
1) Discuss the difference in the two articles and then 2) research at least one additional credible source (skipping Investopedia/Wikipedia basically) that deepens the discussion, supporting the concept of the market having the “bigger picture” in mind. 3) From your supporting article(s), indicate what are the “other market forces” that are being factored in and how/why each affects stock (and/or bond) prices.
Hint one possible idea: There have been some interesting articles reporting how some Americans are spending their stimulus checks.
This week’s discussion and news articles are to put the apparent anomaly of our “class assumptions” vs. market reality in perspective.
Merriam Webster: Market forces are the actions of buyers and sellers that cause the prices of goods and services to change without being controlled by the government: the economic forces of supply and demand.