Lecture Notes: Expectations in Economics

Introduction to Expectations

• Expectations are crucial in economics and finance.
• Decision-making by firms, consumers, and governments often involves future considerations.
• In finance, the value of assets is heavily based on future expectations.

Current Events

• First Republic Bank Collapse
  • Recently liquidated and sold to JP Morgan.
  • Collapsed due to vulnerabilities from rising interest rates.
  • Experienced a massive run on deposits, losing about $100 billion recently.
  • Reflects the importance of expectations in banking.

S&P 500 and NASDAQ Overview

• S&P 500
  • Represents major US companies.
  • Shows substantial variation based on economic events and policies.
  • Influenced by expectations of economic conditions and policies.
• NASDAQ
  • Heavily technology-oriented.
  • Exhibits even larger swings than the S&P 500.

Bond Market Dynamics

• Price Movements
  • Even safe assets like US Treasury bonds show large price movements.
  • Influenced by monetary policy and interest rate expectations.

Key Concept: Expected Present Discounted Value

• Essential for determining fair asset prices.
• Expectations: Future cash flows and interest rates.
• Present Discounted Value: Comparing future values to present terms using discount rates/interest rates.

Discounting Future Cash Flows

• Interest rates are used to discount future values.
• A future dollar is worth less than a present dollar, especially as interest rates rise.
• Equations derive the present value of future cash flows based on current and expected future interest rates.

Examples

• Bonds are often used to illustrate discounting principles.
• Variances in bond pricing reflect changes in interest rate expectations.

Yield Curve and Term Structure of Interest Rates

• Yield Curve: Shows relationship between maturity and yield.
• Term Structure: Defines yields at various maturities.
• Inverted Yield Curve: Indicates economic expectations like impending recessions or inflation concerns.

Arbitrage and Asset Pricing

• Arbitrage contrasts investments to ensure consistent returns across similar risk profiles.
• Used to price bonds and lay the foundation for yield calculation.

Bonds Yields and Arbitrage

• Yield to Maturity: Rate that makes bond price equal to present discounted value.
• Reflects average expected future short-term rates.
• Expectation Hypothesis: Long-term rates equal the average of short-term rates.

Conclusion

• Understanding expectations and their impact on asset valuation is crucial for economics and finance.
• Yield curves and bond yields provide insight into market expectations and economic conditions.