WEBVTT 00:00:00.000 --> 00:00:00.988 align:middle line:90% 00:00:00.988 --> 00:00:02.470 align:middle line:90% [SQUEAKING] 00:00:02.470 --> 00:00:03.952 align:middle line:90% [RUSTLING] 00:00:03.952 --> 00:00:05.434 align:middle line:90% [CLICKING] 00:00:05.434 --> 00:00:17.212 align:middle line:90% 00:00:17.212 --> 00:00:18.670 align:middle line:84% RICARDO J. CABALLERO: OK, so let me 00:00:18.670 --> 00:00:21.820 align:middle line:84% continue with the topic of the previous lecture, which 00:00:21.820 --> 00:00:23.560 align:middle line:90% is asset pricing. 00:00:23.560 --> 00:00:26.290 align:middle line:84% And we said the tricky thing with asset pricing 00:00:26.290 --> 00:00:31.570 align:middle line:84% is that the payoff of having an asset comes in the future. 00:00:31.570 --> 00:00:36.380 align:middle line:84% And that implies at least two things. 00:00:36.380 --> 00:00:41.740 align:middle line:84% The first one is that we need to have a method to value returns 00:00:41.740 --> 00:00:45.070 align:middle line:90% in the future as of today, OK? 00:00:45.070 --> 00:00:46.700 align:middle line:90% So what is it equivalent to? 00:00:46.700 --> 00:00:48.700 align:middle line:84% After all, if you want to buy a financial asset, 00:00:48.700 --> 00:00:51.940 align:middle line:84% you need to pay for it today with dollars of today, 00:00:51.940 --> 00:00:55.760 align:middle line:84% and you are expected to receive some payoff in the future. 00:00:55.760 --> 00:00:57.980 align:middle line:84% You need to be able to compare these two things. 00:00:57.980 --> 00:01:00.560 align:middle line:84% And the second is that-- is related, 00:01:00.560 --> 00:01:03.250 align:middle line:84% is that because this payoff is in the future, 00:01:03.250 --> 00:01:06.190 align:middle line:84% you need to have expectations about it. 00:01:06.190 --> 00:01:11.590 align:middle line:84% So those are the two concepts we play with. 00:01:11.590 --> 00:01:13.750 align:middle line:84% And it's a third related concept, 00:01:13.750 --> 00:01:16.630 align:middle line:84% which is, because it comes in the future, 00:01:16.630 --> 00:01:18.500 align:middle line:84% many things can happen in between. 00:01:18.500 --> 00:01:20.930 align:middle line:84% And so there is also a concept of risk. 00:01:20.930 --> 00:01:23.960 align:middle line:84% Those are the three elements we discussed. 00:01:23.960 --> 00:01:26.357 align:middle line:90% And remember, we did-- 00:01:26.357 --> 00:01:27.940 align:middle line:84% I'm going to go very quickly over what 00:01:27.940 --> 00:01:31.600 align:middle line:84% we did in the previous lecture because I could see some faces. 00:01:31.600 --> 00:01:36.640 align:middle line:84% So let me go quickly over that and then continue with equity, 00:01:36.640 --> 00:01:40.020 align:middle line:90% which was the next step. 00:01:40.020 --> 00:01:43.950 align:middle line:84% So the first step says, OK, ignore the expectations part 00:01:43.950 --> 00:01:45.560 align:middle line:90% for now and risk and so on. 00:01:45.560 --> 00:01:47.290 align:middle line:90% Assume that you know the future. 00:01:47.290 --> 00:01:52.800 align:middle line:84% And we ask the question, well, how do we value $1 next year? 00:01:52.800 --> 00:01:55.020 align:middle line:84% In particular, we want the question, 00:01:55.020 --> 00:01:57.360 align:middle line:84% is it equivalent to having $1 today? 00:01:57.360 --> 00:01:59.490 align:middle line:84% And the answer quickly became no, 00:01:59.490 --> 00:02:01.710 align:middle line:84% because imagine that you had the dollar today. 00:02:01.710 --> 00:02:04.830 align:middle line:84% Then you can invest it for a year, 00:02:04.830 --> 00:02:08.699 align:middle line:84% and you get the return of the one-year interest rate return. 00:02:08.699 --> 00:02:13.970 align:middle line:84% So with a $1 today, you can do more than with $1 in the future. 00:02:13.970 --> 00:02:17.390 align:middle line:84% In fact, that calculation gave us 00:02:17.390 --> 00:02:22.880 align:middle line:84% the exact recipe to valuing $1 in the future, because in order 00:02:22.880 --> 00:02:25.440 align:middle line:84% to get $1 in the future, I don't need $1 today. 00:02:25.440 --> 00:02:28.490 align:middle line:84% I need 1 over 1 plus the interest rate. 00:02:28.490 --> 00:02:32.600 align:middle line:84% I invest this in the one-year bond, 00:02:32.600 --> 00:02:36.290 align:middle line:84% and I get a return of that over that amount. 00:02:36.290 --> 00:02:38.760 align:middle line:84% That gives me exactly $1 in the future, OK? 00:02:38.760 --> 00:02:43.070 align:middle line:84% So that gives us a very natural way of valuing $1 next year. 00:02:43.070 --> 00:02:45.510 align:middle line:84% It's just 1 over 1 plus the interest rate. 00:02:45.510 --> 00:02:48.680 align:middle line:84% And by the same logic, if I have $1 today, 00:02:48.680 --> 00:02:50.810 align:middle line:84% and I want to invest it for two years, 00:02:50.810 --> 00:02:52.940 align:middle line:84% well, I'm going to earn that interest 00:02:52.940 --> 00:02:54.050 align:middle line:90% rate for the first year. 00:02:54.050 --> 00:02:57.080 align:middle line:84% And then I'm going to earn that interest 00:02:57.080 --> 00:03:00.800 align:middle line:84% rate on the full product, not on the original $1. 00:03:00.800 --> 00:03:07.050 align:middle line:84% On the 1 plus i t dollars, I'm going to earn 1 plus i t plus 1. 00:03:07.050 --> 00:03:11.270 align:middle line:90% And so I can generate a lot of-- 00:03:11.270 --> 00:03:15.090 align:middle line:84% [CHUCKLES] if the interest rate is 10% on average, $1 today 00:03:15.090 --> 00:03:19.480 align:middle line:84% generates $1.21 two years from now. 00:03:19.480 --> 00:03:25.680 align:middle line:84% So that tells you, by the same logic, that 1 over $1.21 00:03:25.680 --> 00:03:29.140 align:middle line:84% today is equivalent to $1 in the future. 00:03:29.140 --> 00:03:33.000 align:middle line:84% So then we said, let's pick a very general asset, 00:03:33.000 --> 00:03:34.620 align:middle line:90% an asset that has-- 00:03:34.620 --> 00:03:39.990 align:middle line:84% that pays Zt dollars this year, then Zt 00:03:39.990 --> 00:03:44.790 align:middle line:84% plus $1 one year from now, Zt plus $2 two years from now 00:03:44.790 --> 00:03:48.790 align:middle line:84% and so on and so forth, up to n years ahead. 00:03:48.790 --> 00:03:51.040 align:middle line:84% What is the value of that asset today? 00:03:51.040 --> 00:03:52.830 align:middle line:84% Well, you apply exactly the same logic 00:03:52.830 --> 00:03:57.060 align:middle line:84% that we apply here for every single year in the future. 00:03:57.060 --> 00:04:00.030 align:middle line:90% And you get-- that's the-- 00:04:00.030 --> 00:04:03.900 align:middle line:84% that's called the present discounted value 00:04:03.900 --> 00:04:05.220 align:middle line:90% of those cash flows. 00:04:05.220 --> 00:04:07.440 align:middle line:90% That gives you the value today. 00:04:07.440 --> 00:04:10.890 align:middle line:84% Present, discounted-- those are the discount factors, 1 over-- 00:04:10.890 --> 00:04:13.420 align:middle line:84% and then that's the value that you get out of that. 00:04:13.420 --> 00:04:17.339 align:middle line:84% So that asset has that present discounted value 00:04:17.339 --> 00:04:22.360 align:middle line:90% of future cash flows. 00:04:22.360 --> 00:04:25.050 align:middle line:84% And that should be more or less the price 00:04:25.050 --> 00:04:27.930 align:middle line:84% that you are willing to pay for that asset, OK? 00:04:27.930 --> 00:04:30.605 align:middle line:90% 00:04:30.605 --> 00:04:32.090 align:middle line:84% And then we introduce expectations. 00:04:32.090 --> 00:04:34.470 align:middle line:84% OK, but we're talking about cash flows in the future. 00:04:34.470 --> 00:04:36.200 align:middle line:90% In many cases, we don't know. 00:04:36.200 --> 00:04:37.680 align:middle line:90% Well, we don't know two things. 00:04:37.680 --> 00:04:41.480 align:middle line:84% First, we don't know where the cash flows may be. 00:04:41.480 --> 00:04:44.510 align:middle line:84% In a very safe bond, you do know the cash flow. 00:04:44.510 --> 00:04:48.440 align:middle line:84% [CHUCKLES] But in almost any other asset, 00:04:48.440 --> 00:04:51.230 align:middle line:84% you don't know exactly the cash flows you receive. 00:04:51.230 --> 00:04:54.650 align:middle line:84% And you don't know what the future interest rate, 00:04:54.650 --> 00:04:57.260 align:middle line:90% one-year interest rate will be. 00:04:57.260 --> 00:05:00.950 align:middle line:84% So that took us to the concept of expected present discounted 00:05:00.950 --> 00:05:03.920 align:middle line:84% value, in which you just replace all the things 00:05:03.920 --> 00:05:07.640 align:middle line:84% we don't know today for the expectations of those things. 00:05:07.640 --> 00:05:09.630 align:middle line:84% So we don't know the cash flows in the future. 00:05:09.630 --> 00:05:12.660 align:middle line:84% That's the reason-- we have an expectation. 00:05:12.660 --> 00:05:13.850 align:middle line:90% That's what you put there. 00:05:13.850 --> 00:05:16.665 align:middle line:84% And we don't know the future-- we know the current interest 00:05:16.665 --> 00:05:19.040 align:middle line:84% rate, but we don't know the future one-year interest rate 00:05:19.040 --> 00:05:21.360 align:middle line:84% or two-year interest rate, end-year interest rate 00:05:21.360 --> 00:05:22.020 align:middle line:90% and so on. 00:05:22.020 --> 00:05:24.920 align:middle line:84% So we put an expectation there, OK? 00:05:24.920 --> 00:05:28.050 align:middle line:90% So that's that. 00:05:28.050 --> 00:05:30.910 align:middle line:84% And then I gave you some special cases. 00:05:30.910 --> 00:05:33.910 align:middle line:84% That's a case in which the interest rate is constant. 00:05:33.910 --> 00:05:37.260 align:middle line:84% That's a case in which the payoff in the future, 00:05:37.260 --> 00:05:42.170 align:middle line:90% the coupons, are constant. 00:05:42.170 --> 00:05:45.080 align:middle line:84% And that's a case in which both are constant, 00:05:45.080 --> 00:05:48.940 align:middle line:84% the interest rate and the payoffs in the future 00:05:48.940 --> 00:05:52.590 align:middle line:84% and for a bond-- for a financial asset that lasts for n 00:05:52.590 --> 00:05:56.230 align:middle line:90% years, that matures in n years. 00:05:56.230 --> 00:05:58.620 align:middle line:84% That's the case in which an asset that does not mature, 00:05:58.620 --> 00:06:01.720 align:middle line:84% that goes on forever under these conditions. 00:06:01.720 --> 00:06:03.900 align:middle line:84% And then I said, well, suppose that we 00:06:03.900 --> 00:06:05.560 align:middle line:90% look at the x dividend price. 00:06:05.560 --> 00:06:09.360 align:middle line:84% That means after this year's dividend or this year's payment, 00:06:09.360 --> 00:06:11.050 align:middle line:90% then that's the value. 00:06:11.050 --> 00:06:13.950 align:middle line:84% And I made the point there that shows immediately 00:06:13.950 --> 00:06:16.920 align:middle line:84% something that will be present in almost any asset price, which 00:06:16.920 --> 00:06:21.635 align:middle line:84% is, as interest rate goes down, asset values tend to go up, OK? 00:06:21.635 --> 00:06:23.970 align:middle line:84% And the reason for that is because assets 00:06:23.970 --> 00:06:26.110 align:middle line:90% pay something in the future. 00:06:26.110 --> 00:06:28.450 align:middle line:84% And if the interest rate falls, then you 00:06:28.450 --> 00:06:29.870 align:middle line:90% discount less the future. 00:06:29.870 --> 00:06:31.328 align:middle line:84% So whatever you're going to receive 00:06:31.328 --> 00:06:34.515 align:middle line:84% is valued more because you discount less the future, OK? 00:06:34.515 --> 00:06:35.940 align:middle line:90% So that's the effect. 00:06:35.940 --> 00:06:37.930 align:middle line:84% In fact, in this particular case, 00:06:37.930 --> 00:06:40.108 align:middle line:84% if the interest rate goes to 0, the value of that 00:06:40.108 --> 00:06:42.400 align:middle line:84% goes to infinity because you don't discount the future, 00:06:42.400 --> 00:06:45.500 align:middle line:84% and you're going to receive infinite payments in the future, 00:06:45.500 --> 00:06:46.000 align:middle line:90% OK? 00:06:46.000 --> 00:06:49.980 align:middle line:90% 00:06:49.980 --> 00:06:52.890 align:middle line:84% Then we look at the specific financial assets. 00:06:52.890 --> 00:06:56.790 align:middle line:90% And we first look at bonds. 00:06:56.790 --> 00:07:00.842 align:middle line:84% And we said one important distinction, something-- 00:07:00.842 --> 00:07:03.300 align:middle line:84% whenever you buy a bond, one of the things you want to know 00:07:03.300 --> 00:07:04.750 align:middle line:90% is the maturity of that bond. 00:07:04.750 --> 00:07:09.070 align:middle line:84% Is it a one-year bond, a two-year bond, five, 10, 30? 00:07:09.070 --> 00:07:12.690 align:middle line:84% Those are the typical US Treasury bonds, at least. 00:07:12.690 --> 00:07:15.860 align:middle line:84% You want to know the maturity of the bond. 00:07:15.860 --> 00:07:20.890 align:middle line:84% So then we went into pricing different bonds. 00:07:20.890 --> 00:07:22.440 align:middle line:90% We say, well, a bond-- 00:07:22.440 --> 00:07:25.400 align:middle line:84% the simplest bond is a bond-- is a one-year bond that-- 00:07:25.400 --> 00:07:29.270 align:middle line:84% suppose we have a bond that pays $100 at the end of the year, 00:07:29.270 --> 00:07:31.580 align:middle line:90% and then it matures. 00:07:31.580 --> 00:07:34.070 align:middle line:84% Well, the price of that bond should 00:07:34.070 --> 00:07:38.330 align:middle line:84% be the present discounted value of the flows of that bond, which 00:07:38.330 --> 00:07:42.140 align:middle line:84% is $100 divided by 1 plus the one-year interest 00:07:42.140 --> 00:07:43.570 align:middle line:90% rate at time t, OK? 00:07:43.570 --> 00:07:47.550 align:middle line:90% 00:07:47.550 --> 00:07:49.913 align:middle line:84% And notice again here, by the same logic 00:07:49.913 --> 00:07:52.080 align:middle line:84% of what I explained before, is that, if the interest 00:07:52.080 --> 00:07:55.050 align:middle line:84% rate, one-year interest rate, goes up, the price of that bond 00:07:55.050 --> 00:07:58.417 align:middle line:84% will decline because that bond pays you one year from now. 00:07:58.417 --> 00:08:00.750 align:middle line:84% And one year from now, when the interest rate is higher, 00:08:00.750 --> 00:08:03.480 align:middle line:84% it's worth a little less than it was when the interest 00:08:03.480 --> 00:08:06.970 align:middle line:90% rate was a little lower, OK? 00:08:06.970 --> 00:08:09.630 align:middle line:84% And then we look at a two-year bond, a bond that pays nothing 00:08:09.630 --> 00:08:10.930 align:middle line:90% up to two years from now. 00:08:10.930 --> 00:08:13.500 align:middle line:84% And we say, well, two years from now, it pays $100 00:08:13.500 --> 00:08:14.660 align:middle line:90% and then matures. 00:08:14.660 --> 00:08:19.700 align:middle line:84% Well, the price of that bond will be this, OK? 00:08:19.700 --> 00:08:22.110 align:middle line:84% And notice that, in this case, the price 00:08:22.110 --> 00:08:25.150 align:middle line:84% of a two-year bond at time t goes down 00:08:25.150 --> 00:08:28.640 align:middle line:84% if either of the one-year rates goes up, OK? 00:08:28.640 --> 00:08:30.330 align:middle line:90% It can be the first-- 00:08:30.330 --> 00:08:34.380 align:middle line:84% this year's one-year rate or maybe the expectation 00:08:34.380 --> 00:08:40.610 align:middle line:84% that the one-year rate next year will go up, OK? 00:08:40.610 --> 00:08:41.990 align:middle line:90% Good. 00:08:41.990 --> 00:08:44.330 align:middle line:84% Then I introduce an important concept, 00:08:44.330 --> 00:08:49.980 align:middle line:84% which is this concept of arbitrage pricing, which is-- 00:08:49.980 --> 00:08:55.275 align:middle line:84% two instruments should give you sort 00:08:55.275 --> 00:08:57.150 align:middle line:84% of the same interest rate-- we're leaving 00:08:57.150 --> 00:08:58.330 align:middle line:90% risk considerations aside. 00:08:58.330 --> 00:09:05.530 align:middle line:84% It should give you the same return when you compare them 00:09:05.530 --> 00:09:07.980 align:middle line:90% over the same maturity, OK? 00:09:07.980 --> 00:09:11.410 align:middle line:84% So in this particular example, I said, 00:09:11.410 --> 00:09:15.700 align:middle line:84% look, a one-year bond and a two-year bond 00:09:15.700 --> 00:09:18.260 align:middle line:84% that you invest-- you hold for only one year 00:09:18.260 --> 00:09:22.920 align:middle line:84% should give you more or less the same return, OK? 00:09:22.920 --> 00:09:29.830 align:middle line:84% So that means that this is the return you get from $1 invested 00:09:29.830 --> 00:09:32.930 align:middle line:90% in a one-year bond-- 00:09:32.930 --> 00:09:34.850 align:middle line:84% should be equal to the return you 00:09:34.850 --> 00:09:38.030 align:middle line:84% get by investing in a two-year bond 00:09:38.030 --> 00:09:40.970 align:middle line:84% and selling that bond after one year. 00:09:40.970 --> 00:09:44.590 align:middle line:84% And that's the expression we had here. 00:09:44.590 --> 00:09:48.900 align:middle line:84% If you-- this is what you pay for a two-year bond. 00:09:48.900 --> 00:09:55.160 align:middle line:84% And this is what you expect to be paid for that bond when 00:09:55.160 --> 00:09:57.000 align:middle line:90% you sell it one year from now. 00:09:57.000 --> 00:09:59.720 align:middle line:84% Notice that, one year from now, the two-year bond 00:09:59.720 --> 00:10:02.743 align:middle line:84% will be a one-year bond because one year will have expired, 00:10:02.743 --> 00:10:04.660 align:middle line:84% and at that point, it will be a one-year bond. 00:10:04.660 --> 00:10:07.760 align:middle line:84% That's the reason we have a subscript P1t here. 00:10:07.760 --> 00:10:10.130 align:middle line:84% So that means that we can solve from here 00:10:10.130 --> 00:10:13.160 align:middle line:90% that P2t is simply that. 00:10:13.160 --> 00:10:15.800 align:middle line:84% But there is an expression like the one 00:10:15.800 --> 00:10:17.900 align:middle line:84% we had for the one-year bond at time t. 00:10:17.900 --> 00:10:19.620 align:middle line:90% There is one for t plus 1. 00:10:19.620 --> 00:10:22.880 align:middle line:84% We put expectations because we don't know the actual interest 00:10:22.880 --> 00:10:24.920 align:middle line:90% rate in the future. 00:10:24.920 --> 00:10:29.310 align:middle line:84% And then I stuck this into there. 00:10:29.310 --> 00:10:32.250 align:middle line:84% And we got exactly the same price 00:10:32.250 --> 00:10:33.720 align:middle line:84% that we got with the net present-- 00:10:33.720 --> 00:10:36.290 align:middle line:84% expected present discounted value approach, OK? 00:10:36.290 --> 00:10:38.280 align:middle line:90% And so this asset pricing-- 00:10:38.280 --> 00:10:40.320 align:middle line:84% this arbitrage way of pricing things 00:10:40.320 --> 00:10:42.630 align:middle line:84% is an incredibly powerful tool that 00:10:42.630 --> 00:10:44.980 align:middle line:84% is used very extensively in finance. 00:10:44.980 --> 00:10:46.230 align:middle line:90% These are simple calculations. 00:10:46.230 --> 00:10:50.190 align:middle line:84% But when an asset gets to be tricky, much more complicated, 00:10:50.190 --> 00:10:54.320 align:middle line:90% this is very useful. 00:10:54.320 --> 00:10:57.140 align:middle line:90% Then we talk about bond yields. 00:10:57.140 --> 00:11:02.120 align:middle line:84% And bond yields are defined as the constant interest 00:11:02.120 --> 00:11:09.220 align:middle line:84% rate that is consistent with the current price 00:11:09.220 --> 00:11:11.170 align:middle line:90% of that particular bond. 00:11:11.170 --> 00:11:14.200 align:middle line:84% So in the case of the two-year bond, 00:11:14.200 --> 00:11:17.650 align:middle line:84% we call the two-year rate, that interest rate 00:11:17.650 --> 00:11:22.100 align:middle line:84% that is constant over the two periods. 00:11:22.100 --> 00:11:23.480 align:middle line:90% That's the reason I square it. 00:11:23.480 --> 00:11:27.500 align:middle line:90% It's not i1t times 1 i1t plus 1. 00:11:27.500 --> 00:11:29.130 align:middle line:90% I square it. 00:11:29.130 --> 00:11:31.020 align:middle line:90% It's not constant over time. 00:11:31.020 --> 00:11:33.010 align:middle line:84% The two-year interest rate may be moving a lot. 00:11:33.010 --> 00:11:35.438 align:middle line:84% I mean, the Fed just hiked by 25 basis points. 00:11:35.438 --> 00:11:37.480 align:middle line:84% I'm sure all the rates are moving at this moment. 00:11:37.480 --> 00:11:40.840 align:middle line:84% So the rates can be moving at all points in time. 00:11:40.840 --> 00:11:43.733 align:middle line:84% But what we define as the yield is, at one point in time, 00:11:43.733 --> 00:11:45.150 align:middle line:84% you tell me the price of the bond, 00:11:45.150 --> 00:11:47.610 align:middle line:84% you tell me the payoff of the bond, then 00:11:47.610 --> 00:11:52.980 align:middle line:84% what is the constant interest rate that makes this price-- 00:11:52.980 --> 00:11:55.480 align:middle line:84% this expression equal to the actual price? 00:11:55.480 --> 00:11:58.780 align:middle line:84% That's the way we define the two-year rate. 00:11:58.780 --> 00:12:00.070 align:middle line:90% That's the two-year rate. 00:12:00.070 --> 00:12:04.380 align:middle line:84% And if you have a bond that pays 100 n years from now, 00:12:04.380 --> 00:12:08.370 align:middle line:84% then there would be a constant interest rate, i n, 00:12:08.370 --> 00:12:17.265 align:middle line:84% that gives you $100 divided by 1 plus i nt to the n power. 00:12:17.265 --> 00:12:20.040 align:middle line:90% That will give you-- 00:12:20.040 --> 00:12:22.710 align:middle line:84% when you set that equal to the price, the actual price 00:12:22.710 --> 00:12:27.000 align:middle line:84% of the bond, the one you get out of expected present discounted 00:12:27.000 --> 00:12:29.500 align:middle line:84% value or out of arbitrage, then you 00:12:29.500 --> 00:12:35.170 align:middle line:84% have found the yield or the yield to maturity. 00:12:35.170 --> 00:12:37.030 align:middle line:84% We know what the-- we already got the price 00:12:37.030 --> 00:12:38.272 align:middle line:90% from the previous slide. 00:12:38.272 --> 00:12:39.730 align:middle line:84% We know that the price of this bond 00:12:39.730 --> 00:12:43.150 align:middle line:84% is going to be 100 as a two-year bond divided 00:12:43.150 --> 00:12:46.030 align:middle line:84% by this product of 1 plus interest rate, one-year interest 00:12:46.030 --> 00:12:46.670 align:middle line:90% rate. 00:12:46.670 --> 00:12:48.770 align:middle line:90% So this has to be equal to that. 00:12:48.770 --> 00:12:52.660 align:middle line:84% That's the way, actually, you calculate the two-year yield. 00:12:52.660 --> 00:12:54.650 align:middle line:90% And numerators are the same. 00:12:54.650 --> 00:12:56.930 align:middle line:84% That means the denominators have to be the same. 00:12:56.930 --> 00:13:00.580 align:middle line:84% And this implies approximately that the two-year rate 00:13:00.580 --> 00:13:05.312 align:middle line:84% is a sort of average of the expected one-year rates, OK? 00:13:05.312 --> 00:13:08.200 align:middle line:84% So in this case, the two-year rate 00:13:08.200 --> 00:13:10.850 align:middle line:84% is a sort of average of the one-year rate. 00:13:10.850 --> 00:13:14.350 align:middle line:84% That means that, when the-- when you expect the interest 00:13:14.350 --> 00:13:17.560 align:middle line:84% rate to be-- the one-year rate to be rising over time, 00:13:17.560 --> 00:13:21.928 align:middle line:84% then the two-year rate will be above the one-year rate today. 00:13:21.928 --> 00:13:24.470 align:middle line:84% That's when the curve is-- we say the curve, the yield curve, 00:13:24.470 --> 00:13:25.610 align:middle line:90% is steep. 00:13:25.610 --> 00:13:27.342 align:middle line:90% Remember I showed you this in-- 00:13:27.342 --> 00:13:31.590 align:middle line:90% 00:13:31.590 --> 00:13:33.080 align:middle line:90% there? 00:13:33.080 --> 00:13:36.800 align:middle line:84% When the curve looks like that, so steep, 00:13:36.800 --> 00:13:41.638 align:middle line:84% means that the later-- the two-year rate, 00:13:41.638 --> 00:13:43.430 align:middle line:84% the three-year-- well, here, in particular, 00:13:43.430 --> 00:13:45.710 align:middle line:84% the three-year rate is-- the two-year rate 00:13:45.710 --> 00:13:47.085 align:middle line:84% is higher than the one-year rate. 00:13:47.085 --> 00:13:49.252 align:middle line:84% The three-year rate is higher than the two-year rate 00:13:49.252 --> 00:13:50.280 align:middle line:90% and so on and so forth. 00:13:50.280 --> 00:13:54.050 align:middle line:90% That happens when you expect-- 00:13:54.050 --> 00:13:55.550 align:middle line:84% the market expects the interest rate 00:13:55.550 --> 00:13:58.040 align:middle line:84% to be rising over time, the one-year rate 00:13:58.040 --> 00:14:02.990 align:middle line:84% to be rising because remember, the two-year rate 00:14:02.990 --> 00:14:05.570 align:middle line:84% is the average of the current one-year rate 00:14:05.570 --> 00:14:08.790 align:middle line:84% plus the expected one-year rate one year from now. 00:14:08.790 --> 00:14:12.180 align:middle line:84% For that average to be higher than the one-year rate now, 00:14:12.180 --> 00:14:15.930 align:middle line:84% it has to be the case that the expected one-year rate one year 00:14:15.930 --> 00:14:19.860 align:middle line:84% from now has to be higher than the current one-year rate, OK? 00:14:19.860 --> 00:14:22.260 align:middle line:90% So that's when you tend to get-- 00:14:22.260 --> 00:14:25.085 align:middle line:84% that's when you get an upward-sloping term structure. 00:14:25.085 --> 00:14:27.210 align:middle line:84% And when you get a downward-sloping term structure, 00:14:27.210 --> 00:14:28.830 align:middle line:84% which is the way it looks right now-- 00:14:28.830 --> 00:14:31.350 align:middle line:84% actually, right now, it looks very downward-sloping. 00:14:31.350 --> 00:14:32.400 align:middle line:90% There you are. 00:14:32.400 --> 00:14:34.560 align:middle line:84% It looks very downward-sloping-- is 00:14:34.560 --> 00:14:38.400 align:middle line:84% people expect that we're getting to the peak of current policy 00:14:38.400 --> 00:14:40.420 align:middle line:84% rate of short-term interest rate. 00:14:40.420 --> 00:14:42.900 align:middle line:84% And so people expect now for the interest rate 00:14:42.900 --> 00:14:45.100 align:middle line:90% to decline going forward. 00:14:45.100 --> 00:14:50.250 align:middle line:84% And that's the reason the two-year rate now is 00:14:50.250 --> 00:14:53.640 align:middle line:90% lower than the one-year rate. 00:14:53.640 --> 00:14:55.990 align:middle line:84% And the five-year rate is lower than the two-year rate 00:14:55.990 --> 00:14:56.590 align:middle line:90% and so on. 00:14:56.590 --> 00:14:59.620 align:middle line:90% 00:14:59.620 --> 00:15:03.620 align:middle line:84% And as you can see here, it's very steep. 00:15:03.620 --> 00:15:07.410 align:middle line:84% Then we said, well, let's add risk because yeah, sure. 00:15:07.410 --> 00:15:11.100 align:middle line:84% Here we assume that you were indifferent between investing 00:15:11.100 --> 00:15:15.007 align:middle line:84% in a completely safe one-year bond and a two-year bond 00:15:15.007 --> 00:15:17.340 align:middle line:84% in which you had to make an expectation about the price. 00:15:17.340 --> 00:15:18.790 align:middle line:84% But that price could move around. 00:15:18.790 --> 00:15:23.070 align:middle line:84% So there is risk on that price, on the price of one-year-- 00:15:23.070 --> 00:15:26.510 align:middle line:90% the one-year bond as of today. 00:15:26.510 --> 00:15:31.040 align:middle line:90% 00:15:31.040 --> 00:15:32.612 align:middle line:90% So we added risk. 00:15:32.612 --> 00:15:34.320 align:middle line:84% And there are two types of risk in bonds. 00:15:34.320 --> 00:15:38.600 align:middle line:84% One is default risk, that they had promised that they would pay 00:15:38.600 --> 00:15:42.410 align:middle line:84% you $100, but it may happen that they cannot pay you the $100, 00:15:42.410 --> 00:15:44.660 align:middle line:84% the corporation or the government or so on. 00:15:44.660 --> 00:15:50.090 align:middle line:84% Argentina defaults its bonds regularly, for example. 00:15:50.090 --> 00:15:54.740 align:middle line:84% Many of the regional banks that have gone under 00:15:54.740 --> 00:15:57.090 align:middle line:84% will default on their bonds as well-- 00:15:57.090 --> 00:15:58.440 align:middle line:90% so that kind of risk. 00:15:58.440 --> 00:16:01.440 align:middle line:84% But we'll remove that risk, and we'll focus, for now, on the-- 00:16:01.440 --> 00:16:03.260 align:middle line:84% I'm going to focus mostly on the price risk 00:16:03.260 --> 00:16:06.510 align:middle line:84% because I'm going to be talking mostly about US Treasury bonds. 00:16:06.510 --> 00:16:09.440 align:middle line:84% US Treasury bonds have no default risk, we think. 00:16:09.440 --> 00:16:12.590 align:middle line:84% I mean, there could be an event in a few weeks from now, 00:16:12.590 --> 00:16:15.630 align:middle line:84% but no one expects that to be a lasting event. 00:16:15.630 --> 00:16:17.400 align:middle line:84% I mean, if it is, there is a real mess. 00:16:17.400 --> 00:16:20.480 align:middle line:84% But in any event, but there is also a price risk 00:16:20.480 --> 00:16:23.990 align:middle line:84% because you have to hold this and then sell it at one year. 00:16:23.990 --> 00:16:27.120 align:middle line:84% And you don't know exactly the price, what the price will be. 00:16:27.120 --> 00:16:29.150 align:middle line:84% There is a risk associated to that. 00:16:29.150 --> 00:16:33.350 align:middle line:84% So that means that, really, you shouldn't equalize 00:16:33.350 --> 00:16:36.800 align:middle line:84% the return on the one-year bond to the return you expect 00:16:36.800 --> 00:16:39.840 align:middle line:90% to get in the two-year bond. 00:16:39.840 --> 00:16:42.020 align:middle line:84% You should add a little compensation 00:16:42.020 --> 00:16:44.600 align:middle line:84% for holding the two-year bond, for going the two-year bond 00:16:44.600 --> 00:16:45.220 align:middle line:90% route. 00:16:45.220 --> 00:16:48.530 align:middle line:84% And so rather than expect to make 00:16:48.530 --> 00:16:54.080 align:middle line:84% 1 plus i1t the two-year bond after one year, 00:16:54.080 --> 00:16:56.480 align:middle line:84% you should expect to earn a little more. 00:16:56.480 --> 00:17:01.640 align:middle line:84% And that's what this xb being positive reflects. 00:17:01.640 --> 00:17:05.300 align:middle line:84% And so in that case, the price of the two-year bond 00:17:05.300 --> 00:17:07.270 align:middle line:84% is a little different from what we had. 00:17:07.270 --> 00:17:09.260 align:middle line:84% In fact, it's a little lower than what 00:17:09.260 --> 00:17:11.849 align:middle line:84% we had because that's the way you compensate for risk. 00:17:11.849 --> 00:17:13.609 align:middle line:84% I sell you an instrument a little cheaper 00:17:13.609 --> 00:17:16.160 align:middle line:84% than it would have been in the absence of risk. 00:17:16.160 --> 00:17:20.160 align:middle line:84% So you expect to get a little-- a slightly higher return out 00:17:20.160 --> 00:17:20.800 align:middle line:90% of that. 00:17:20.800 --> 00:17:24.720 align:middle line:84% So this price is lower than the price without the risk 00:17:24.720 --> 00:17:26.930 align:middle line:90% premium here, no? 00:17:26.930 --> 00:17:28.680 align:middle line:84% That means-- but it still is promising you 00:17:28.680 --> 00:17:32.190 align:middle line:84% $100 So that's exactly how you get more return out of it, 00:17:32.190 --> 00:17:34.770 align:middle line:84% because you're buying something at a lower price, OK? 00:17:34.770 --> 00:17:43.865 align:middle line:90% 00:17:43.865 --> 00:17:46.420 align:middle line:84% So I can do the same logic now and see 00:17:46.420 --> 00:17:48.500 align:middle line:90% what the two-year rate is. 00:17:48.500 --> 00:17:50.710 align:middle line:90% But now that I have this-- 00:17:50.710 --> 00:17:52.810 align:middle line:84% take into account this risk, and you 00:17:52.810 --> 00:17:55.660 align:middle line:84% have that the two-year rate now is the average not only 00:17:55.660 --> 00:17:58.930 align:middle line:84% of the expected one-year rate, but also includes 00:17:58.930 --> 00:18:02.146 align:middle line:90% a risk premium. 00:18:02.146 --> 00:18:04.660 align:middle line:84% And that tends to be the case, that the further out 00:18:04.660 --> 00:18:07.200 align:middle line:84% in the curve you are, the larger is the risk premium. 00:18:07.200 --> 00:18:11.162 align:middle line:84% It's called term premium because term is the same as maturity, 00:18:11.162 --> 00:18:11.662 align:middle line:90% OK? 00:18:11.662 --> 00:18:16.850 align:middle line:90% 00:18:16.850 --> 00:18:21.580 align:middle line:84% Actually, sometimes that is negative, actually. 00:18:21.580 --> 00:18:24.830 align:middle line:84% And recently, up to very recently-- now it's positive. 00:18:24.830 --> 00:18:28.332 align:middle line:84% But until very recently, that xb was negative. 00:18:28.332 --> 00:18:30.790 align:middle line:84% And the reason for that-- you don't need to understand that 00:18:30.790 --> 00:18:31.360 align:middle line:90% now-- 00:18:31.360 --> 00:18:35.470 align:middle line:84% is because long-term bonds were great hedges. 00:18:35.470 --> 00:18:37.690 align:middle line:90% Meaning, if there is-- 00:18:37.690 --> 00:18:41.110 align:middle line:84% for any major event, for a financial crisis or something 00:18:41.110 --> 00:18:44.260 align:middle line:84% like that, because in a financial crisis 00:18:44.260 --> 00:18:49.120 align:middle line:84% or a major disaster, interest rates tend to fall. 00:18:49.120 --> 00:18:51.855 align:middle line:84% And when interest rates fall, the price of bonds goes up, 00:18:51.855 --> 00:18:53.706 align:middle line:90% [CHUCKLES] OK? 00:18:53.706 --> 00:18:55.450 align:middle line:90% And so that was a good hedge. 00:18:55.450 --> 00:18:58.510 align:middle line:84% If you wanted to protect your portfolio of equities 00:18:58.510 --> 00:19:02.140 align:middle line:84% and so on against a major catastrophic-- major event 00:19:02.140 --> 00:19:05.380 align:middle line:84% like a financial crisis or a war or something 00:19:05.380 --> 00:19:08.950 align:middle line:84% like that, it was not a bad idea to have some long-term US 00:19:08.950 --> 00:19:11.200 align:middle line:84% Treasury bonds in your portfolio, 00:19:11.200 --> 00:19:14.770 align:middle line:84% because they would tend to go up precisely when everything 00:19:14.770 --> 00:19:17.860 align:middle line:84% else was going to be losing money and so, as a result, 00:19:17.860 --> 00:19:18.860 align:middle line:90% tend to be negative. 00:19:18.860 --> 00:19:22.030 align:middle line:84% Now that's not the case, because now one of the biggest risks 00:19:22.030 --> 00:19:23.540 align:middle line:90% is inflation. 00:19:23.540 --> 00:19:27.290 align:middle line:84% And so if there is an inflationary spike, 00:19:27.290 --> 00:19:30.450 align:middle line:84% then interest rates will go down-- up, not down. 00:19:30.450 --> 00:19:32.430 align:middle line:84% And that means the price of bonds will decline. 00:19:32.430 --> 00:19:34.760 align:middle line:84% So they will decline at the wrong time, OK? 00:19:34.760 --> 00:19:37.040 align:middle line:84% So the price of bonds, of long-term bonds, 00:19:37.040 --> 00:19:40.340 align:middle line:84% now will tend to decline when everything else is also 00:19:40.340 --> 00:19:40.890 align:middle line:90% plummeting. 00:19:40.890 --> 00:19:43.550 align:middle line:84% I mean, if we get a negative, if we get an inflation surprise, 00:19:43.550 --> 00:19:46.310 align:middle line:84% and inflation is a lot higher than people expected, 00:19:46.310 --> 00:19:48.740 align:middle line:84% asset prices are going to decline, all of them, 00:19:48.740 --> 00:19:50.310 align:middle line:90% including long-term bonds. 00:19:50.310 --> 00:19:56.160 align:middle line:84% And that's the reason now this xb is positive. 00:19:56.160 --> 00:19:58.500 align:middle line:84% OK, so that's-- so I think that's where we were 00:19:58.500 --> 00:20:01.050 align:middle line:90% at in the previous lecture. 00:20:01.050 --> 00:20:02.680 align:middle line:90% Any questions about that? 00:20:02.680 --> 00:20:06.780 align:middle line:84% Then I'm going to-- next step is to talk about equity. 00:20:06.780 --> 00:20:07.620 align:middle line:90% No? 00:20:07.620 --> 00:20:08.670 align:middle line:90% Yeah? 00:20:08.670 --> 00:20:11.670 align:middle line:84% AUDIENCE: Why don't we add the risk premium to the interest 00:20:11.670 --> 00:20:12.880 align:middle line:90% rate on your note? 00:20:12.880 --> 00:20:14.893 align:middle line:90% 00:20:14.893 --> 00:20:16.810 align:middle line:84% RICARDO J. CABALLERO: Well, because next year, 00:20:16.810 --> 00:20:21.790 align:middle line:84% that one-- for this particular bond, that bond 00:20:21.790 --> 00:20:25.190 align:middle line:84% will have no risk because it will be one year to go. 00:20:25.190 --> 00:20:28.570 align:middle line:84% And at the end of that year, you're going to get the $100. 00:20:28.570 --> 00:20:30.430 align:middle line:90% So there is no risk, that $100. 00:20:30.430 --> 00:20:32.505 align:middle line:84% If it was a three-year bond, then 00:20:32.505 --> 00:20:33.880 align:middle line:84% you would have-- in two of those, 00:20:33.880 --> 00:20:36.192 align:middle line:90% you would have risk premium. 00:20:36.192 --> 00:20:37.900 align:middle line:84% But you wouldn't have it in the last one, 00:20:37.900 --> 00:20:39.910 align:middle line:84% because in the last one, you don't have the-- you're 00:20:39.910 --> 00:20:40.993 align:middle line:90% going to receive the $100. 00:20:40.993 --> 00:20:41.860 align:middle line:90% [CHUCKLES] 00:20:41.860 --> 00:20:45.990 align:middle line:90% If the bond could default-- 00:20:45.990 --> 00:20:49.680 align:middle line:84% because I'm only looking at price risk in the bond. 00:20:49.680 --> 00:20:55.200 align:middle line:84% If the bond could default, then I would add an extra term there 00:20:55.200 --> 00:20:56.500 align:middle line:90% because it's default risk. 00:20:56.500 --> 00:20:59.040 align:middle line:84% But here I'm just looking at price risk. 00:20:59.040 --> 00:21:01.900 align:middle line:84% And I'm assuming the unit of time is one year. 00:21:01.900 --> 00:21:04.390 align:middle line:84% So just one year before it expires, 00:21:04.390 --> 00:21:07.440 align:middle line:84% there is no more risk because there is no price in between, 00:21:07.440 --> 00:21:12.070 align:middle line:84% and you're going to receive $100 at the end of a year. 00:21:12.070 --> 00:21:15.190 align:middle line:90% In reality, time is continuous. 00:21:15.190 --> 00:21:17.597 align:middle line:84% So every second, there is a little bit of a risk. 00:21:17.597 --> 00:21:19.680 align:middle line:84% So you have a little bit of that risk all the time 00:21:19.680 --> 00:21:21.450 align:middle line:90% except for the last second. 00:21:21.450 --> 00:21:26.310 align:middle line:84% But I'm looking at a simple example, where things 00:21:26.310 --> 00:21:27.928 align:middle line:90% happen every one year only. 00:21:27.928 --> 00:21:31.420 align:middle line:90% 00:21:31.420 --> 00:21:33.950 align:middle line:84% In the book, I think they mess up, actually. 00:21:33.950 --> 00:21:37.770 align:middle line:84% They put the risk premium in the wrong place. 00:21:37.770 --> 00:21:39.992 align:middle line:90% There was another question. 00:21:39.992 --> 00:21:41.900 align:middle line:90% No? 00:21:41.900 --> 00:21:43.940 align:middle line:90% OK. 00:21:43.940 --> 00:21:48.850 align:middle line:84% So let's look at the stock prices now. 00:21:48.850 --> 00:21:52.845 align:middle line:84% So stock prices have two key differences with respect to-- 00:21:52.845 --> 00:21:55.990 align:middle line:90% 00:21:55.990 --> 00:21:59.680 align:middle line:84% well, several differences, but two that I want to highlight. 00:21:59.680 --> 00:22:02.480 align:middle line:84% The first is that they don't pay coupons, fixed amount. 00:22:02.480 --> 00:22:05.320 align:middle line:84% They don't promise you to pay $100 two years 00:22:05.320 --> 00:22:07.260 align:middle line:90% from now or anything like that. 00:22:07.260 --> 00:22:09.690 align:middle line:90% They pay dividends. 00:22:09.690 --> 00:22:13.450 align:middle line:84% They tell you we have a policy of paying dividends. 00:22:13.450 --> 00:22:15.870 align:middle line:84% And even different companies differentiate themselves 00:22:15.870 --> 00:22:19.480 align:middle line:84% by how much they promise to give you on average in dividends. 00:22:19.480 --> 00:22:22.207 align:middle line:84% But it's a promise that, if everything goes as planned, 00:22:22.207 --> 00:22:23.540 align:middle line:90% they'll pay you those dividends. 00:22:23.540 --> 00:22:28.017 align:middle line:84% [CHUCKLES] It's not a commitment to pay you a dividend. 00:22:28.017 --> 00:22:29.350 align:middle line:90% It's very different from a bond. 00:22:29.350 --> 00:22:32.460 align:middle line:84% A bond says, I'll pay you a coupon of this amount every six 00:22:32.460 --> 00:22:33.760 align:middle line:90% months. 00:22:33.760 --> 00:22:37.010 align:middle line:84% And if you don't pay that coupon, that's a default. 00:22:37.010 --> 00:22:38.790 align:middle line:84% There's nothing like that in equity. 00:22:38.790 --> 00:22:41.390 align:middle line:84% Equity, you buy shares of Apple, and you 00:22:41.390 --> 00:22:43.040 align:middle line:84% look at the history of dividends, 00:22:43.040 --> 00:22:47.990 align:middle line:84% what the CEO tells you the last time, in the last release. 00:22:47.990 --> 00:22:51.448 align:middle line:84% And you think, OK, these are more or less 00:22:51.448 --> 00:22:52.490 align:middle line:90% going to be my dividends. 00:22:52.490 --> 00:22:55.040 align:middle line:90% But there's no commitment. 00:22:55.040 --> 00:22:58.550 align:middle line:84% They will always tell you what's their plan. 00:22:58.550 --> 00:22:59.690 align:middle line:90% But it's a plan. 00:22:59.690 --> 00:23:00.660 align:middle line:90% It's not a commitment. 00:23:00.660 --> 00:23:01.550 align:middle line:90% So that's the first thing. 00:23:01.550 --> 00:23:03.717 align:middle line:84% It doesn't have fixed coupons or anything like that. 00:23:03.717 --> 00:23:04.830 align:middle line:90% There's no commitment. 00:23:04.830 --> 00:23:07.190 align:middle line:84% And in that sense, there is no sense of default, 00:23:07.190 --> 00:23:08.640 align:middle line:90% because there was no commitment. 00:23:08.640 --> 00:23:12.470 align:middle line:84% So there is no default. If a company has 00:23:12.470 --> 00:23:15.410 align:middle line:84% to cut dividends to 0, that's not a default. 00:23:15.410 --> 00:23:17.350 align:middle line:90% That's conditions change. 00:23:17.350 --> 00:23:17.850 align:middle line:90% That's it. 00:23:17.850 --> 00:23:19.800 align:middle line:90% There was no commitment to that. 00:23:19.800 --> 00:23:23.730 align:middle line:84% The second feature is that they don't have a fixed terminal 00:23:23.730 --> 00:23:25.190 align:middle line:90% date. 00:23:25.190 --> 00:23:29.720 align:middle line:84% 99.9999999% of the bonds do have a terminal date. 00:23:29.720 --> 00:23:30.950 align:middle line:90% They have a maturity. 00:23:30.950 --> 00:23:35.080 align:middle line:84% There is a few exceptions, which are called perpetuities, that-- 00:23:35.080 --> 00:23:37.520 align:middle line:84% I think the US has none, for example. 00:23:37.520 --> 00:23:44.140 align:middle line:84% But most bonds have a maturity, OK? 00:23:44.140 --> 00:23:45.710 align:middle line:90% Equity doesn't come that way. 00:23:45.710 --> 00:23:47.610 align:middle line:84% Nobody tells you buy a share of Apple. 00:23:47.610 --> 00:23:51.550 align:middle line:84% You don't buy shares of Apple that 00:23:51.550 --> 00:23:54.340 align:middle line:84% will be retired 30 years from now, OK? 00:23:54.340 --> 00:23:56.640 align:middle line:84% There will be there as long as Apple exists. 00:23:56.640 --> 00:23:59.878 align:middle line:90% 00:23:59.878 --> 00:24:03.970 align:middle line:84% Of course, if you had shares of First Republic Bank, 00:24:03.970 --> 00:24:07.100 align:middle line:84% you have nothing now [CHUCKLES] because that-- 00:24:07.100 --> 00:24:08.950 align:middle line:84% but that was not the original plan. 00:24:08.950 --> 00:24:11.300 align:middle line:84% It First Republic Bank had been more successful, 00:24:11.300 --> 00:24:12.325 align:middle line:90% you would have-- 00:24:12.325 --> 00:24:16.450 align:middle line:84% the shares would have survived for a very long period of time. 00:24:16.450 --> 00:24:18.130 align:middle line:90% So there's no sense of maturity. 00:24:18.130 --> 00:24:21.105 align:middle line:84% In principle, equity can last forever. 00:24:21.105 --> 00:24:27.330 align:middle line:90% 00:24:27.330 --> 00:24:33.050 align:middle line:84% So I'm going to use arbitrage to price equity. 00:24:33.050 --> 00:24:38.390 align:middle line:84% So let me-- so it lets me have the following 00:24:38.390 --> 00:24:41.150 align:middle line:90% portfolio of options here. 00:24:41.150 --> 00:24:44.660 align:middle line:90% One is our old one-year bond. 00:24:44.660 --> 00:24:48.210 align:middle line:84% So you can invest your dollar today in a one-year bond. 00:24:48.210 --> 00:24:50.060 align:middle line:84% The alternative, I'm going to say, 00:24:50.060 --> 00:24:51.470 align:middle line:90% there is some equity out there. 00:24:51.470 --> 00:24:54.740 align:middle line:84% And I'm going to call the price of that equity Q 00:24:54.740 --> 00:24:59.832 align:middle line:84% and the dividend of that equity D, OK? 00:24:59.832 --> 00:25:03.780 align:middle line:90% 00:25:03.780 --> 00:25:06.670 align:middle line:84% So this price is a stock by arbitrage. 00:25:06.670 --> 00:25:09.480 align:middle line:90% So equity is risky. 00:25:09.480 --> 00:25:14.070 align:middle line:84% I mean, it's much riskier than bonds 00:25:14.070 --> 00:25:16.540 align:middle line:84% unless you are into Argentinian bonds or things like that. 00:25:16.540 --> 00:25:18.480 align:middle line:84% But I mean, it's much riskier than bonds. 00:25:18.480 --> 00:25:20.770 align:middle line:84% So there is always a risk premium. 00:25:20.770 --> 00:25:22.710 align:middle line:84% And actually, that in itself is a trade, 00:25:22.710 --> 00:25:25.390 align:middle line:84% should trade at risk premium of equity market. 00:25:25.390 --> 00:25:27.280 align:middle line:90% So I'm going to put an xs here. 00:25:27.280 --> 00:25:31.980 align:middle line:84% So what do you expect to get from holding-- 00:25:31.980 --> 00:25:33.970 align:middle line:84% arbitrage means the same holding period. 00:25:33.970 --> 00:25:37.980 align:middle line:84% So I'm going to compare investing in a one-year safe 00:25:37.980 --> 00:25:44.150 align:middle line:84% bond versus buying equity today, buying a stock, 00:25:44.150 --> 00:25:49.240 align:middle line:84% holding it for a year, And then selling it there 00:25:49.240 --> 00:25:50.530 align:middle line:90% because that's the same-- 00:25:50.530 --> 00:25:53.870 align:middle line:84% I cannot do arbitrage depending from different holding periods. 00:25:53.870 --> 00:25:55.450 align:middle line:84% That's a one-year holding period. 00:25:55.450 --> 00:25:58.520 align:middle line:84% So I'm saying this is what I'm going to get from the bond. 00:25:58.520 --> 00:26:01.000 align:middle line:84% I'm going to require some risk compensation for that 00:26:01.000 --> 00:26:03.410 align:middle line:90% because risk equity is risky. 00:26:03.410 --> 00:26:04.570 align:middle line:90% So I'm going to want that. 00:26:04.570 --> 00:26:06.060 align:middle line:84% And this is what I'm going to get. 00:26:06.060 --> 00:26:07.630 align:middle line:84% That's my return on equity I get. 00:26:07.630 --> 00:26:10.220 align:middle line:84% This is what I'm going to pay today for the stock-- 00:26:10.220 --> 00:26:12.250 align:middle line:90% say, for a share of Apple. 00:26:12.250 --> 00:26:14.440 align:middle line:84% And when I get this, this is the dividend 00:26:14.440 --> 00:26:17.770 align:middle line:84% I expect to get at the end of the year. 00:26:17.770 --> 00:26:19.570 align:middle line:84% And then this is the price at which 00:26:19.570 --> 00:26:25.240 align:middle line:84% I expect to sell that share one year from now, OK? 00:26:25.240 --> 00:26:27.310 align:middle line:84% So that's the return I'm expecting 00:26:27.310 --> 00:26:31.430 align:middle line:84% to get from holding the share of Apple for one period. 00:26:31.430 --> 00:26:34.270 align:middle line:84% And that's what I need to compare with holding 00:26:34.270 --> 00:26:36.700 align:middle line:90% for one year, one-year bond. 00:26:36.700 --> 00:26:44.320 align:middle line:84% But I want also to be compensated for a risk, OK? 00:26:44.320 --> 00:26:46.970 align:middle line:90% Good. 00:26:46.970 --> 00:26:47.665 align:middle line:90% Is this clear? 00:26:47.665 --> 00:26:51.270 align:middle line:90% 00:26:51.270 --> 00:26:53.100 align:middle line:90% OK. 00:26:53.100 --> 00:26:54.990 align:middle line:84% I don't know whether silence means yes or no. 00:26:54.990 --> 00:26:57.660 align:middle line:84% But this is-- we did something like this 00:26:57.660 --> 00:26:59.610 align:middle line:84% with the two-year bond, except that we didn't 00:26:59.610 --> 00:27:03.300 align:middle line:84% have a dividend there, because there 00:27:03.300 --> 00:27:04.930 align:middle line:90% was no coupon that they won. 00:27:04.930 --> 00:27:07.290 align:middle line:84% We only had a final payment of 100. 00:27:07.290 --> 00:27:10.680 align:middle line:84% But we did this already when we compared the one-year bond 00:27:10.680 --> 00:27:13.200 align:middle line:84% with holding the two-year bond for one period. 00:27:13.200 --> 00:27:15.120 align:middle line:84% We had exactly that, except that there 00:27:15.120 --> 00:27:16.560 align:middle line:84% was-- the expected dividend. there 00:27:16.560 --> 00:27:18.870 align:middle line:84% was 0 because there was no payment 00:27:18.870 --> 00:27:21.940 align:middle line:90% at the intermediate date, OK? 00:27:21.940 --> 00:27:22.440 align:middle line:90% Good. 00:27:22.440 --> 00:27:24.580 align:middle line:90% So we know this concept already. 00:27:24.580 --> 00:27:26.240 align:middle line:84% The only difference here is, again, 00:27:26.240 --> 00:27:29.390 align:middle line:84% that there is expected dividend and, second, 00:27:29.390 --> 00:27:32.790 align:middle line:84% that we have a risk premium here, which we added for bonds. 00:27:32.790 --> 00:27:34.460 align:middle line:84% But for equities, I said, it's typically 00:27:34.460 --> 00:27:37.130 align:middle line:84% much larger than for bonds, especially if you're 00:27:37.130 --> 00:27:38.755 align:middle line:90% talking about Treasury bonds. 00:27:38.755 --> 00:27:41.560 align:middle line:90% 00:27:41.560 --> 00:27:43.480 align:middle line:84% So I'm going to reorganize this to solve out 00:27:43.480 --> 00:27:45.445 align:middle line:90% for the price, this Qt here. 00:27:45.445 --> 00:27:46.820 align:middle line:84% That's what I want to figure out, 00:27:46.820 --> 00:27:49.510 align:middle line:84% what is the price of the share of Apple, OK? 00:27:49.510 --> 00:27:55.930 align:middle line:84% Well, I can reorganize this, which means move to the left, 00:27:55.930 --> 00:28:00.370 align:middle line:84% divide these two guys here by 1 plus i1t plus xs, 00:28:00.370 --> 00:28:02.260 align:middle line:90% and I get this. 00:28:02.260 --> 00:28:08.777 align:middle line:84% So the price is equal to the discounted expected dividend-- 00:28:08.777 --> 00:28:10.360 align:middle line:84% I have to discount it because I expect 00:28:10.360 --> 00:28:13.780 align:middle line:84% to receive it one year from now, and I want also compensation 00:28:13.780 --> 00:28:14.950 align:middle line:90% for risk-- 00:28:14.950 --> 00:28:19.360 align:middle line:84% plus the discounted value of the money 00:28:19.360 --> 00:28:21.670 align:middle line:84% I'm going to get from selling the share of Apple one 00:28:21.670 --> 00:28:26.470 align:middle line:84% year from now, which I also discount by the interest rate, 00:28:26.470 --> 00:28:28.420 align:middle line:84% but also with a risk premium because that's 00:28:28.420 --> 00:28:31.570 align:middle line:90% a risky investment. 00:28:31.570 --> 00:28:34.480 align:middle line:90% So that's what we have. 00:28:34.480 --> 00:28:43.940 align:middle line:84% Now notice that, at t plus 1, I will have an expression 00:28:43.940 --> 00:28:48.000 align:middle line:90% like that as well, again. 00:28:48.000 --> 00:28:50.580 align:middle line:84% When we did the two-year bond, we 00:28:50.580 --> 00:28:55.590 align:middle line:84% didn't have an expression like that, because after one year, 00:28:55.590 --> 00:28:57.930 align:middle line:84% the two-year bond was going to be a one-year bond. 00:28:57.930 --> 00:28:59.610 align:middle line:90% And so we didn't need to think-- 00:28:59.610 --> 00:29:00.640 align:middle line:90% put a price there. 00:29:00.640 --> 00:29:02.610 align:middle line:90% We just put the $100, OK? 00:29:02.610 --> 00:29:06.150 align:middle line:84% Here is different because we said this equity never expires. 00:29:06.150 --> 00:29:09.580 align:middle line:84% Unless the company goes bankrupt, it's there. 00:29:09.580 --> 00:29:13.090 align:middle line:84% So in the next date, I'm going to have an expression exactly 00:29:13.090 --> 00:29:13.930 align:middle line:90% like that. 00:29:13.930 --> 00:29:18.250 align:middle line:84% I'm just going to have an expected dividend at t plus 2 00:29:18.250 --> 00:29:22.360 align:middle line:84% and the expected price at t plus 2 and so on and so forth. 00:29:22.360 --> 00:29:26.830 align:middle line:84% That means I can replace this expression here 00:29:26.830 --> 00:29:30.795 align:middle line:84% by an expression like this shifted all by one year. 00:29:30.795 --> 00:29:33.400 align:middle line:90% 00:29:33.400 --> 00:29:36.940 align:middle line:90% And I can keep doing that. 00:29:36.940 --> 00:29:39.580 align:middle line:84% If I do that, I'm going to get, then, two 00:29:39.580 --> 00:29:42.970 align:middle line:84% expected divisions here, and then I'm going to get a-- 00:29:42.970 --> 00:29:45.730 align:middle line:84% so I'm going to get something like this, 00:29:45.730 --> 00:29:48.880 align:middle line:84% but shifted by one year and discounted by two terms 00:29:48.880 --> 00:29:49.850 align:middle line:90% in the denominator. 00:29:49.850 --> 00:29:54.010 align:middle line:84% And then I'm going to get an expected Qt plus 2 00:29:54.010 --> 00:29:55.720 align:middle line:90% around here, OK? 00:29:55.720 --> 00:30:00.380 align:middle line:84% Well, I can do a substitution of that, as well, again, 00:30:00.380 --> 00:30:03.020 align:middle line:84% by everything shifted by two years and so on. 00:30:03.020 --> 00:30:05.160 align:middle line:90% So I can keep going. 00:30:05.160 --> 00:30:09.240 align:middle line:84% And I can keep going and going and going and going on forever. 00:30:09.240 --> 00:30:11.730 align:middle line:84% So if you keep doing it, you're going 00:30:11.730 --> 00:30:14.400 align:middle line:84% to end up with an expression that gives you 00:30:14.400 --> 00:30:18.870 align:middle line:84% the price of the asset as the expected present discounted 00:30:18.870 --> 00:30:21.410 align:middle line:84% value of all the future dividends you expect. 00:30:21.410 --> 00:30:24.510 align:middle line:90% 00:30:24.510 --> 00:30:25.050 align:middle line:90% You see? 00:30:25.050 --> 00:30:29.420 align:middle line:84% I'm summing here, Dt plus 2, 3, 4, 5. 00:30:29.420 --> 00:30:31.790 align:middle line:90% And it doesn't stop here. 00:30:31.790 --> 00:30:39.890 align:middle line:84% It stop here, I'm going to have here a Qet plus n plus 1. 00:30:39.890 --> 00:30:41.600 align:middle line:84% Well, I can replace that thing again. 00:30:41.600 --> 00:30:44.060 align:middle line:84% And I can keep going and keep going forever. 00:30:44.060 --> 00:30:46.880 align:middle line:84% So you're going to integrate the expected dividends, discounted 00:30:46.880 --> 00:30:51.020 align:middle line:90% expected dividends, to infinity. 00:30:51.020 --> 00:30:54.350 align:middle line:84% Now, each future dividend is discounting more and more 00:30:54.350 --> 00:30:56.195 align:middle line:84% heavily because the denominator is growing 00:30:56.195 --> 00:30:58.820 align:middle line:84% and growing and growing because it's further out in the future. 00:30:58.820 --> 00:31:01.022 align:middle line:90% It's worth less and less, OK? 00:31:01.022 --> 00:31:03.200 align:middle line:90% But still, it can go on forever. 00:31:03.200 --> 00:31:06.650 align:middle line:84% And in fact, even if you substitute this stuff a million 00:31:06.650 --> 00:31:08.600 align:middle line:84% times, there is going to still be 00:31:08.600 --> 00:31:10.970 align:middle line:84% a little price at the very end floating 00:31:10.970 --> 00:31:13.790 align:middle line:90% around [LAUGHS] discounted. 00:31:13.790 --> 00:31:16.040 align:middle line:90% It will never go away. 00:31:16.040 --> 00:31:17.850 align:middle line:90% So it never ends. 00:31:17.850 --> 00:31:19.220 align:middle line:90% There is no maturity. 00:31:19.220 --> 00:31:22.670 align:middle line:90% They keep going, OK? 00:31:22.670 --> 00:31:25.510 align:middle line:84% Now we did everything up to now for nominal-- 00:31:25.510 --> 00:31:27.970 align:middle line:90% in nominal terms you can do it-- 00:31:27.970 --> 00:31:30.880 align:middle line:84% and that's the reason I didn't want to spend much time with it. 00:31:30.880 --> 00:31:33.760 align:middle line:84% You can do everything in real terms as well. 00:31:33.760 --> 00:31:37.240 align:middle line:84% And all that happens there is just remove the dollars, 00:31:37.240 --> 00:31:41.830 align:middle line:84% and just be careful to replace the nominal interest 00:31:41.830 --> 00:31:44.650 align:middle line:84% rate by the real interest rate-- but nothing deep there. 00:31:44.650 --> 00:31:48.290 align:middle line:84% I can-- you can go to real pricing, nominal pricing, 00:31:48.290 --> 00:31:50.610 align:middle line:90% and so on. 00:31:50.610 --> 00:31:53.700 align:middle line:84% But the important concept is not that. 00:31:53.700 --> 00:31:56.880 align:middle line:90% It's the fact that this-- 00:31:56.880 --> 00:32:01.170 align:middle line:84% in principle-- we call that, by the way, the fundamental value 00:32:01.170 --> 00:32:04.620 align:middle line:90% of equity or of a stock. 00:32:04.620 --> 00:32:06.180 align:middle line:84% It's the expected present discounted 00:32:06.180 --> 00:32:07.453 align:middle line:90% value of all the dividends. 00:32:07.453 --> 00:32:09.870 align:middle line:84% And you have to discount it by the appropriate discounting 00:32:09.870 --> 00:32:12.610 align:middle line:84% factor, which includes interest rate and risk premium. 00:32:12.610 --> 00:32:14.670 align:middle line:84% But that's what we call, typically, fundamentals. 00:32:14.670 --> 00:32:17.777 align:middle line:84% And we differentiate that from what we call sometimes-- 00:32:17.777 --> 00:32:19.860 align:middle line:84% I'm going to show you an example later on bubbles, 00:32:19.860 --> 00:32:24.900 align:middle line:84% when the price seems to exceed any reasonable sense 00:32:24.900 --> 00:32:26.110 align:middle line:90% of fundamentals. 00:32:26.110 --> 00:32:32.630 align:middle line:90% 00:32:32.630 --> 00:32:34.300 align:middle line:90% OK, good. 00:32:34.300 --> 00:32:40.700 align:middle line:84% OK, let me sort of start going back to things that we 00:32:40.700 --> 00:32:41.880 align:middle line:90% worry about in this course. 00:32:41.880 --> 00:32:43.060 align:middle line:90% And in fact, it's a big issue. 00:32:43.060 --> 00:32:44.977 align:middle line:84% I don't know what is happening to markets now. 00:32:44.977 --> 00:32:46.830 align:middle line:84% What the Fed did was very anticipated. 00:32:46.830 --> 00:32:50.000 align:middle line:90% 00:32:50.000 --> 00:32:53.690 align:middle line:84% But markets often find a way to react to things, 00:32:53.690 --> 00:32:57.830 align:middle line:90% even if things were anticipated. 00:32:57.830 --> 00:33:01.677 align:middle line:84% What happens-- so let me ask you a following question. 00:33:01.677 --> 00:33:03.260 align:middle line:84% What is the effect-- what do you think 00:33:03.260 --> 00:33:08.870 align:middle line:84% is the effect of an expansionary monetary policy on the asset 00:33:08.870 --> 00:33:13.060 align:middle line:84% prices we have discussed, so bonds and equity? 00:33:13.060 --> 00:33:16.660 align:middle line:90% Let's start with bonds first. 00:33:16.660 --> 00:33:19.142 align:middle line:84% What do you think is the effect of an expansionary monetary 00:33:19.142 --> 00:33:21.100 align:middle line:84% policy-- that means a reduction in the interest 00:33:21.100 --> 00:33:24.370 align:middle line:84% rate-- on the price of your one-year bond, two-year bond, 00:33:24.370 --> 00:33:25.425 align:middle line:90% any year, you pick? 00:33:25.425 --> 00:33:30.133 align:middle line:90% 00:33:30.133 --> 00:33:31.675 align:middle line:84% We already talked about that earlier. 00:33:31.675 --> 00:33:36.720 align:middle line:90% [CHUCKLES] Goes up. 00:33:36.720 --> 00:33:41.730 align:middle line:84% The price of a bond is inversely related to the interest rate 00:33:41.730 --> 00:33:45.750 align:middle line:84% because if I cut an interest rate, it means-- 00:33:45.750 --> 00:33:49.030 align:middle line:84% a bond is something that pays-- the payoff is in the future. 00:33:49.030 --> 00:33:52.070 align:middle line:84% That thing in the future is worth more 00:33:52.070 --> 00:33:54.790 align:middle line:90% if the interest rate goes down. 00:33:54.790 --> 00:33:56.300 align:middle line:90% There is less discounting of it. 00:33:56.300 --> 00:33:58.360 align:middle line:84% So the price of the bond, any bond here, 00:33:58.360 --> 00:34:00.910 align:middle line:84% will go up, the one-year, two-year, three-year, five-year. 00:34:00.910 --> 00:34:04.620 align:middle line:90% All of them will go up-- 00:34:04.620 --> 00:34:07.800 align:middle line:84% assuming that nothing changes as a result of the monetary policy. 00:34:07.800 --> 00:34:10.380 align:middle line:84% What happens is sometimes markets think, 00:34:10.380 --> 00:34:12.000 align:middle line:90% oops, the Fed messed up. 00:34:12.000 --> 00:34:14.400 align:middle line:84% And that leads to lots of changes in all the term 00:34:14.400 --> 00:34:16.889 align:middle line:84% structure and things like that because they 00:34:16.889 --> 00:34:19.080 align:middle line:84% expect the market to react in strange ways 00:34:19.080 --> 00:34:21.310 align:middle line:90% to this mistake made by the Fed. 00:34:21.310 --> 00:34:23.280 align:middle line:84% But here I'm saying, suppose that the Fed just 00:34:23.280 --> 00:34:25.080 align:middle line:84% cuts the interest rate once, and everyone 00:34:25.080 --> 00:34:27.639 align:middle line:84% believes that the Fed will continue to do so and so on. 00:34:27.639 --> 00:34:31.210 align:middle line:84% Well, then you're going to get that-- 00:34:31.210 --> 00:34:33.810 align:middle line:90% the price of bonds will go up. 00:34:33.810 --> 00:34:37.500 align:middle line:84% What will happen to the price of stocks? 00:34:37.500 --> 00:34:39.150 align:middle line:90% Yeah, you want to answer. 00:34:39.150 --> 00:34:39.952 align:middle line:90% [LAUGHS] 00:34:39.952 --> 00:34:41.159 align:middle line:90% AUDIENCE: It would go up. 00:34:41.159 --> 00:34:42.880 align:middle line:90% RICARDO J. CABALLERO: Up. 00:34:42.880 --> 00:34:47.199 align:middle line:84% But-- well, but it's important to say that it will go up 00:34:47.199 --> 00:34:49.030 align:middle line:90% probably for two reasons. 00:34:49.030 --> 00:34:51.580 align:middle line:90% The first one is that-- 00:34:51.580 --> 00:34:55.739 align:middle line:90% 00:34:55.739 --> 00:34:59.850 align:middle line:84% it's also the case that a lot of the price of an equity, actually 00:34:59.850 --> 00:35:03.390 align:middle line:84% even more so than a bond, has to do with expected 00:35:03.390 --> 00:35:05.140 align:middle line:90% payoffs in the future. 00:35:05.140 --> 00:35:07.950 align:middle line:84% So if I lower interest rates, just the effect of discounting 00:35:07.950 --> 00:35:10.610 align:middle line:84% will tend to raise the price of-- 00:35:10.610 --> 00:35:12.660 align:middle line:84% so even if I don't change the expected dividends 00:35:12.660 --> 00:35:15.690 align:middle line:84% at all, the fact that the interest rate goes down, 00:35:15.690 --> 00:35:18.150 align:middle line:84% for the same reason that the price of a bond went up, 00:35:18.150 --> 00:35:20.610 align:middle line:84% the price of equity will tend to go up, OK? 00:35:20.610 --> 00:35:23.350 align:middle line:84% So that's exactly-- it's the same logic. 00:35:23.350 --> 00:35:27.420 align:middle line:84% But there's an extra kick here for equity, which is what? 00:35:27.420 --> 00:35:31.370 align:middle line:84% That bones did not have, but equity does. 00:35:31.370 --> 00:35:34.220 align:middle line:84% At least it's an equity that is positively 00:35:34.220 --> 00:35:35.663 align:middle line:90% related to aggregate activity. 00:35:35.663 --> 00:35:37.080 align:middle line:84% But that's what I'm assuming here. 00:35:37.080 --> 00:35:42.503 align:middle line:90% 00:35:42.503 --> 00:35:47.860 align:middle line:84% AUDIENCE: [INAUDIBLE] bond is [INAUDIBLE] fixed amount 00:35:47.860 --> 00:35:52.210 align:middle line:84% before stocks and can't guarantee that pays you 00:35:52.210 --> 00:35:53.690 align:middle line:90% the same dividend. 00:35:53.690 --> 00:35:56.290 align:middle line:84% RICARDO J. CABALLERO: Well, yeah, that's the logic. 00:35:56.290 --> 00:35:58.537 align:middle line:84% Here, the expansionary monetary policy 00:35:58.537 --> 00:35:59.620 align:middle line:90% is cutting interest rates. 00:35:59.620 --> 00:36:02.050 align:middle line:84% But as a result of that, output is going up. 00:36:02.050 --> 00:36:05.800 align:middle line:84% When output is going up, sales will go up, revenues will go up, 00:36:05.800 --> 00:36:07.900 align:middle line:84% dividends will probably go up as well. 00:36:07.900 --> 00:36:11.330 align:middle line:84% So monetary policy can have very large effect. 00:36:11.330 --> 00:36:14.163 align:middle line:84% I mean, people in financial markets are looking at the Fed 00:36:14.163 --> 00:36:15.580 align:middle line:84% all the time [CHUCKLES] because it 00:36:15.580 --> 00:36:19.210 align:middle line:84% can have a big impact on the price of those assets. 00:36:19.210 --> 00:36:22.400 align:middle line:84% And on equity, in particular, it can be very strong. 00:36:22.400 --> 00:36:27.070 align:middle line:84% And in fact, that's one of the ways monetary policy works. 00:36:27.070 --> 00:36:31.590 align:middle line:84% When the Fed cuts interest rates, 00:36:31.590 --> 00:36:33.670 align:middle line:84% it inflates the value of asset prices. 00:36:33.670 --> 00:36:35.260 align:middle line:90% And that creates more wealth. 00:36:35.260 --> 00:36:37.072 align:middle line:84% People feel richer, consume more, blah, 00:36:37.072 --> 00:36:38.030 align:middle line:90% blah, blah, blah, blah. 00:36:38.030 --> 00:36:39.535 align:middle line:90% Firms feel also richer. 00:36:39.535 --> 00:36:41.570 align:middle line:84% [CHUCKLES] They invest more and so on. 00:36:41.570 --> 00:36:45.790 align:middle line:90% That's deliberate, in a sense. 00:36:45.790 --> 00:36:47.470 align:middle line:84% That's one of the main mechanisms 00:36:47.470 --> 00:36:50.870 align:middle line:84% through which monetary policy affects aggregate demand. 00:36:50.870 --> 00:36:52.620 align:middle line:90% It just creates wealth. 00:36:52.620 --> 00:36:54.690 align:middle line:84% And when there's too much demand, too much 00:36:54.690 --> 00:36:57.120 align:middle line:84% aggregate demand, like is going on now-- 00:36:57.120 --> 00:36:59.730 align:middle line:84% that's the reason we have inflation and so on. 00:36:59.730 --> 00:37:03.630 align:middle line:84% In 2022, the Fed went out and deliberately destroyed 00:37:03.630 --> 00:37:07.860 align:middle line:84% wealth [CHUCKLES] because that's what [INAUDIBLE] Raise interest 00:37:07.860 --> 00:37:09.900 align:middle line:84% rates a lot, the price of equity came down, 00:37:09.900 --> 00:37:12.215 align:middle line:90% even houses began to wobble. 00:37:12.215 --> 00:37:16.120 align:middle line:84% The price of Treasury bonds sort of collapsed 00:37:16.120 --> 00:37:19.040 align:middle line:90% and so on and so forth, OK? 00:37:19.040 --> 00:37:21.160 align:middle line:90% Good. 00:37:21.160 --> 00:37:25.120 align:middle line:84% Another experiment that we did sort of early on, lecture 3, 4, 00:37:25.120 --> 00:37:29.010 align:middle line:84% around there is what happens-- what do you think 00:37:29.010 --> 00:37:32.250 align:middle line:84% happens when there is an increase in consumer spending? 00:37:32.250 --> 00:37:33.390 align:middle line:90% So suppose that now-- 00:37:33.390 --> 00:37:36.750 align:middle line:84% remember, we had a C0 floating around, an autonomous 00:37:36.750 --> 00:37:38.580 align:middle line:90% consumption component. 00:37:38.580 --> 00:37:40.745 align:middle line:84% And so suppose that that goes up. 00:37:40.745 --> 00:37:43.420 align:middle line:90% 00:37:43.420 --> 00:37:47.260 align:middle line:84% What do you think happens to asset prices? 00:37:47.260 --> 00:37:49.957 align:middle line:84% And this is a big issue these days, actually. 00:37:49.957 --> 00:37:52.290 align:middle line:84% AUDIENCE: That depends on how the Federal Reserve reacts 00:37:52.290 --> 00:37:54.030 align:middle line:84% to it by raising or lowering interest rates. 00:37:54.030 --> 00:37:54.720 align:middle line:90% RICARDO J. CABALLERO: Exactly. 00:37:54.720 --> 00:37:55.480 align:middle line:90% That's right. 00:37:55.480 --> 00:37:57.170 align:middle line:90% That's very good. 00:37:57.170 --> 00:37:58.390 align:middle line:90% It depends a lot-- 00:37:58.390 --> 00:38:01.230 align:middle line:84% I mean, when financial markets receive news-- every day, 00:38:01.230 --> 00:38:04.260 align:middle line:84% they are releases of news of all sorts of things. 00:38:04.260 --> 00:38:08.430 align:middle line:84% And in financial markets, they-- people always 00:38:08.430 --> 00:38:10.830 align:middle line:90% think, OK, this is the news. 00:38:10.830 --> 00:38:13.890 align:middle line:84% The obvious thing for this is good news 00:38:13.890 --> 00:38:15.840 align:middle line:84% because this will tend to increase output. 00:38:15.840 --> 00:38:17.290 align:middle line:90% Output will increase dividends. 00:38:17.290 --> 00:38:21.630 align:middle line:90% That's a good thing for stocks. 00:38:21.630 --> 00:38:25.110 align:middle line:84% But the immediate reaction is, whoa, but what will 00:38:25.110 --> 00:38:26.290 align:middle line:90% the Fed do about this? 00:38:26.290 --> 00:38:30.280 align:middle line:84% Does the Fed like that we have more aggregate demand or not? 00:38:30.280 --> 00:38:32.166 align:middle line:90% [CHUCKLES] OK? 00:38:32.166 --> 00:38:36.600 align:middle line:90% And so that's key here. 00:38:36.600 --> 00:38:41.310 align:middle line:84% So suppose that, in this case, the Fed did not like-- 00:38:41.310 --> 00:38:43.950 align:middle line:84% the Fed-- like today, the Fed doesn't want 00:38:43.950 --> 00:38:45.660 align:middle line:90% more aggregate demand today. 00:38:45.660 --> 00:38:48.130 align:middle line:84% There's no central bank around the world-- maybe in China, 00:38:48.130 --> 00:38:49.740 align:middle line:84% but there's no other central bank 00:38:49.740 --> 00:38:55.305 align:middle line:84% around the world that wants more aggregate demand, OK? 00:38:55.305 --> 00:39:03.240 align:middle line:84% So if the release is consumer are very bullish now, 00:39:03.240 --> 00:39:05.330 align:middle line:90% that's not good news. 00:39:05.330 --> 00:39:07.830 align:middle line:84% I mean, the financial markets immediately are saying, uh-oh, 00:39:07.830 --> 00:39:10.330 align:middle line:84% we have a Fed that is watching for inflation. 00:39:10.330 --> 00:39:13.850 align:middle line:84% This means they're going to hike interest rates, OK? 00:39:13.850 --> 00:39:18.120 align:middle line:84% So what happens to the price of bonds, then, in this environment 00:39:18.120 --> 00:39:20.870 align:middle line:84% when C0 goes up, and the Fed doesn't like it, 00:39:20.870 --> 00:39:23.390 align:middle line:84% and the markets know that the Fed doesn't like it? 00:39:23.390 --> 00:39:25.670 align:middle line:84% The Fed may take a month to react to it. 00:39:25.670 --> 00:39:28.070 align:middle line:84% But markets react immediately, say, whoa, this 00:39:28.070 --> 00:39:31.956 align:middle line:84% is what the Fed will do one month from now. 00:39:31.956 --> 00:39:35.150 align:middle line:84% So what do you think happens to the price of bonds? 00:39:35.150 --> 00:39:39.490 align:middle line:84% If we get news that consumers are very bullish, 00:39:39.490 --> 00:39:44.230 align:middle line:84% and it turns out that we also have inflation of 4% or so. 00:39:44.230 --> 00:39:48.123 align:middle line:84% So we know that the Fed doesn't like more aggregate demand. 00:39:48.123 --> 00:39:50.290 align:middle line:84% What do you think will happen to the price of bonds? 00:39:50.290 --> 00:39:56.630 align:middle line:90% 00:39:56.630 --> 00:40:05.230 align:middle line:84% Well, [CHUCKLES] again, The news happened, say, a week ago. 00:40:05.230 --> 00:40:07.520 align:middle line:84% And the Fed moves one week later. 00:40:07.520 --> 00:40:11.050 align:middle line:84% So markets are going to anticipate that, in this case, 00:40:11.050 --> 00:40:14.080 align:middle line:84% the Fed will hike interest rates. 00:40:14.080 --> 00:40:15.818 align:middle line:84% If the Fed-- if the markets anticipate 00:40:15.818 --> 00:40:17.360 align:middle line:84% that the Fed will hike interest rate, 00:40:17.360 --> 00:40:20.815 align:middle line:84% interest rates will go up immediately-- not the rate 00:40:20.815 --> 00:40:22.690 align:middle line:84% that the Fed controls, but the one-year rate, 00:40:22.690 --> 00:40:24.357 align:middle line:84% the two-year rate, the three-month rate. 00:40:24.357 --> 00:40:26.770 align:middle line:84% All those rates are going to go up immediately 00:40:26.770 --> 00:40:28.865 align:middle line:90% as a result of that, OK? 00:40:28.865 --> 00:40:33.170 align:middle line:84% And that, we know, reduces the price of bonds. 00:40:33.170 --> 00:40:35.380 align:middle line:84% Bonds and interest rates are-- the price of a bond 00:40:35.380 --> 00:40:37.320 align:middle line:84% and the interest rates are inversely related. 00:40:37.320 --> 00:40:40.000 align:middle line:84% So the anticipation that the Fed will hike rates 00:40:40.000 --> 00:40:43.120 align:middle line:84% will lead to higher interest rates at all horizons. 00:40:43.120 --> 00:40:46.920 align:middle line:84% And that will reduce the price of bonds, OK? 00:40:46.920 --> 00:40:50.470 align:middle line:84% So this thing that-- and for equity, 00:40:50.470 --> 00:40:52.800 align:middle line:84% well, look what happened for equity here. 00:40:52.800 --> 00:40:54.760 align:middle line:84% Well, for equity, you say, OK, well, I 00:40:54.760 --> 00:40:57.820 align:middle line:84% get the same discounting effect of the bond, which is bad news, 00:40:57.820 --> 00:41:00.640 align:middle line:90% goes down. 00:41:00.640 --> 00:41:03.265 align:middle line:84% Ah, but the good news is the dividend because now 00:41:03.265 --> 00:41:04.750 align:middle line:90% I have more consumers. 00:41:04.750 --> 00:41:08.290 align:middle line:84% Well, that depends on how much the Fed dislikes this stuff 00:41:08.290 --> 00:41:11.570 align:middle line:84% because if the Fed does this, that means it offsets-- 00:41:11.570 --> 00:41:16.040 align:middle line:84% it fully offsets the effect on aggregate demand, 00:41:16.040 --> 00:41:18.650 align:middle line:84% increases the serial shift [INAUDIBLE] to the right. 00:41:18.650 --> 00:41:20.575 align:middle line:84% That would have increased output to here. 00:41:20.575 --> 00:41:21.950 align:middle line:84% The Fed doesn't want more output, 00:41:21.950 --> 00:41:23.325 align:middle line:84% so it will hike interest rates up 00:41:23.325 --> 00:41:25.460 align:middle line:84% to the point in which output doesn't go up. 00:41:25.460 --> 00:41:28.740 align:middle line:84% That means dividends are not going to go up either. 00:41:28.740 --> 00:41:31.560 align:middle line:84% So we get just the negative effect of the discounting, 00:41:31.560 --> 00:41:34.410 align:middle line:84% and we don't get the benefit of the extra activity that 00:41:34.410 --> 00:41:36.540 align:middle line:84% would have come from having consumers that are 00:41:36.540 --> 00:41:39.630 align:middle line:90% more optimistic and so on, OK? 00:41:39.630 --> 00:41:41.540 align:middle line:84% So this is-- actually, this has happened 00:41:41.540 --> 00:41:45.260 align:middle line:90% a lot over the last few months. 00:41:45.260 --> 00:41:47.570 align:middle line:84% This is an environment people call-- 00:41:47.570 --> 00:41:51.320 align:middle line:84% it's an environment where good news is bad news. 00:41:51.320 --> 00:41:53.123 align:middle line:84% Good news about aggregate demand, consumers 00:41:53.123 --> 00:41:54.540 align:middle line:84% are happy, blah, blah, blah, blah. 00:41:54.540 --> 00:41:55.460 align:middle line:90% It's bad news. 00:41:55.460 --> 00:41:58.610 align:middle line:84% Or labor markets are very tight, wages are going up, 00:41:58.610 --> 00:42:02.330 align:middle line:84% all things that sound wonderful in other environments sound-- 00:42:02.330 --> 00:42:06.860 align:middle line:84% is terrible news for the financial markets, OK? 00:42:06.860 --> 00:42:07.775 align:middle line:90% For most, I mean. 00:42:07.775 --> 00:42:09.900 align:middle line:84% There is difference in different sectors and so on. 00:42:09.900 --> 00:42:13.290 align:middle line:84% But for the aggregate, for the average, it's bad news. 00:42:13.290 --> 00:42:16.592 align:middle line:84% So this is an environment where good news is bad news, good news 00:42:16.592 --> 00:42:17.550 align:middle line:90% about aggregate demand. 00:42:17.550 --> 00:42:19.008 align:middle line:84% You have to be specific about what. 00:42:19.008 --> 00:42:23.020 align:middle line:84% Good news about aggregate demand is bad news for asset markets. 00:42:23.020 --> 00:42:24.730 align:middle line:90% It's not always like that. 00:42:24.730 --> 00:42:28.805 align:middle line:84% If you're in a recession, the Fed doesn't want to fight that. 00:42:28.805 --> 00:42:30.430 align:middle line:84% It wants to have more aggregate demand. 00:42:30.430 --> 00:42:32.388 align:middle line:84% So if you get good news about aggregate demand, 00:42:32.388 --> 00:42:34.170 align:middle line:84% that's very good news for asset prices 00:42:34.170 --> 00:42:36.420 align:middle line:84% because the Fed will not offset that, 00:42:36.420 --> 00:42:38.940 align:middle line:84% and you get the positive effect of the extra dividends 00:42:38.940 --> 00:42:40.700 align:middle line:90% and things of that kind, OK? 00:42:40.700 --> 00:42:45.640 align:middle line:90% 00:42:45.640 --> 00:42:49.100 align:middle line:84% Another component that moves asset prices a lot-- 00:42:49.100 --> 00:42:53.155 align:middle line:84% so monetary policy moves asset prices a lot, OK? 00:42:53.155 --> 00:42:55.160 align:middle line:84% But monetary policy doesn't happen 00:42:55.160 --> 00:42:58.615 align:middle line:84% in some separate, isolated space. 00:42:58.615 --> 00:43:00.520 align:middle line:84% It reacts to news about the economy, 00:43:00.520 --> 00:43:04.570 align:middle line:84% about consumers, about firms, about regional banks, 00:43:04.570 --> 00:43:07.770 align:middle line:90% all sorts of things, OK? 00:43:07.770 --> 00:43:10.650 align:middle line:84% Another big driver of asset prices 00:43:10.650 --> 00:43:15.710 align:middle line:84% is this guy here, of equity in particular, 00:43:15.710 --> 00:43:18.470 align:middle line:90% is this risk premium. 00:43:18.470 --> 00:43:21.850 align:middle line:84% So that risk premium can move a lot. 00:43:21.850 --> 00:43:25.840 align:middle line:84% And it's an important driver of asset prices. 00:43:25.840 --> 00:43:28.650 align:middle line:84% This index, this is the-- it's called VIX. 00:43:28.650 --> 00:43:31.090 align:middle line:84% VIX is-- I'm not going to explain what it is. 00:43:31.090 --> 00:43:34.810 align:middle line:84% But people call it, so you get the picture, an index 00:43:34.810 --> 00:43:36.970 align:middle line:90% of fear in equity markets. 00:43:36.970 --> 00:43:40.220 align:middle line:84% It's done-- well, I'm not going to tell you what it is. 00:43:40.220 --> 00:43:44.000 align:middle line:84% It's based on option prices and so on. 00:43:44.000 --> 00:43:48.740 align:middle line:84% So this is when people realized that COVID [CHUCKLES] 00:43:48.740 --> 00:43:50.010 align:middle line:90% was coming. 00:43:50.010 --> 00:43:54.160 align:middle line:84% And so what you see is that this thing exploded up-- 00:43:54.160 --> 00:44:00.070 align:middle line:84% big risk-off, thus a massive spike in the little xs. 00:44:00.070 --> 00:44:03.750 align:middle line:84% Well, not surprisingly, look what happened to equity-- 00:44:03.750 --> 00:44:05.850 align:middle line:90% collapsed by 35% or so. 00:44:05.850 --> 00:44:08.130 align:middle line:84% Part of that was expected deviance, blah, blah, blah, 00:44:08.130 --> 00:44:09.120 align:middle line:90% blah, blah, blah. 00:44:09.120 --> 00:44:11.610 align:middle line:84% But a lot of it was the risk-off. 00:44:11.610 --> 00:44:16.170 align:middle line:84% And it's called risk-off when markets are very fearful. 00:44:16.170 --> 00:44:20.101 align:middle line:84% They don't want to take risks, risk-off, OK? 00:44:20.101 --> 00:44:22.680 align:middle line:84% The recovery, actually, also had a lot 00:44:22.680 --> 00:44:26.450 align:middle line:84% to do with the recovery on the risk environment. 00:44:26.450 --> 00:44:29.180 align:middle line:84% People sort of got used to the thing. 00:44:29.180 --> 00:44:31.250 align:middle line:84% But that recovery also was a result 00:44:31.250 --> 00:44:33.240 align:middle line:84% of very aggressive monetary policy. 00:44:33.240 --> 00:44:37.190 align:middle line:84% The Fed tried to offset this by cutting interest rates very 00:44:37.190 --> 00:44:40.530 align:middle line:84% aggressively, and that also gave a boost to asset prices. 00:44:40.530 --> 00:44:43.460 align:middle line:84% In fact, they did so much that we ended up with a big-- 00:44:43.460 --> 00:44:46.080 align:middle line:84% lots of overvaluation in asset prices. 00:44:46.080 --> 00:44:47.990 align:middle line:84% And then, as a result, when they hiked rates, 00:44:47.990 --> 00:44:54.320 align:middle line:84% we had a big decline in asset prices as a result. 00:44:54.320 --> 00:44:55.220 align:middle line:90% What is this? 00:44:55.220 --> 00:45:00.290 align:middle line:84% Look, this is-- over the weekend-- 00:45:00.290 --> 00:45:04.340 align:middle line:84% over the weekend-- we talked about this 00:45:04.340 --> 00:45:07.040 align:middle line:90% in the previous lecture. 00:45:07.040 --> 00:45:11.900 align:middle line:84% Essentially, the First Republic Bank went under, 00:45:11.900 --> 00:45:15.500 align:middle line:90% and JPMorgan absorbed it. 00:45:15.500 --> 00:45:18.920 align:middle line:90% So people thought that-- 00:45:18.920 --> 00:45:21.800 align:middle line:84% and Monday was good because people thought 00:45:21.800 --> 00:45:26.060 align:middle line:90% that this mini crisis was over. 00:45:26.060 --> 00:45:33.440 align:middle line:84% Well, yesterday, it turns out that two other regional banks, 00:45:33.440 --> 00:45:35.720 align:middle line:84% the shares began to collapse in the same way 00:45:35.720 --> 00:45:39.200 align:middle line:84% as the First Republic Bank shares collapsed 00:45:39.200 --> 00:45:40.590 align:middle line:90% the week before. 00:45:40.590 --> 00:45:43.290 align:middle line:90% So panic immediately set in. 00:45:43.290 --> 00:45:46.880 align:middle line:84% So the VIX, the fear index, [WHISTLES] this is intraday. 00:45:46.880 --> 00:45:52.280 align:middle line:84% So markets open here, And the shares of these two banks 00:45:52.280 --> 00:45:54.490 align:middle line:90% began to decline very rapidly. 00:45:54.490 --> 00:45:58.310 align:middle line:90% And so VIX went up a lot. 00:45:58.310 --> 00:45:59.990 align:middle line:90% And what-- this is-- 00:45:59.990 --> 00:46:04.160 align:middle line:84% this is the main-- this is the SPX, the main-- 00:46:04.160 --> 00:46:05.120 align:middle line:90% S&P 500. 00:46:05.120 --> 00:46:09.230 align:middle line:84% It's the main price index, equity price index, in the US-- 00:46:09.230 --> 00:46:11.510 align:middle line:90% immediately declined. 00:46:11.510 --> 00:46:14.300 align:middle line:90% So that's the xs moving. 00:46:14.300 --> 00:46:17.840 align:middle line:90% Here, xs move up, the little x. 00:46:17.840 --> 00:46:20.450 align:middle line:84% And then it began to come down, and the markets 00:46:20.450 --> 00:46:21.650 align:middle line:90% began to recover. 00:46:21.650 --> 00:46:26.420 align:middle line:84% So this risk on and off is a very big driver 00:46:26.420 --> 00:46:27.580 align:middle line:90% of equity prices. 00:46:27.580 --> 00:46:31.960 align:middle line:90% 00:46:31.960 --> 00:46:35.055 align:middle line:84% This is one of the banks, actually, that was in trouble. 00:46:35.055 --> 00:46:37.560 align:middle line:90% 00:46:37.560 --> 00:46:45.550 align:middle line:84% You see that-- by the end of the day-- this is PacWest. 00:46:45.550 --> 00:46:49.060 align:middle line:84% PacWest had declined by 28% by the end of the day. 00:46:49.060 --> 00:46:51.070 align:middle line:84% But you see things look very weird here. 00:46:51.070 --> 00:46:54.090 align:middle line:84% They don't look like normal prices. 00:46:54.090 --> 00:46:55.720 align:middle line:84% Here they look like normal prices. 00:46:55.720 --> 00:46:57.330 align:middle line:90% They're moving all the time. 00:46:57.330 --> 00:46:58.870 align:middle line:90% Here, they don't. 00:46:58.870 --> 00:47:00.420 align:middle line:84% What happens is that these prices 00:47:00.420 --> 00:47:02.670 align:middle line:84% decline so rapidly that they trigger what 00:47:02.670 --> 00:47:04.360 align:middle line:90% is called circuit breakers. 00:47:04.360 --> 00:47:09.670 align:middle line:84% So you cannot trade those shares when they decline too rapidly. 00:47:09.670 --> 00:47:12.420 align:middle line:84% And that's done deliberately so this little x 00:47:12.420 --> 00:47:15.700 align:middle line:84% doesn't get completely out of control, people to calm down. 00:47:15.700 --> 00:47:21.030 align:middle line:84% And so it triggered it several times. 00:47:21.030 --> 00:47:23.640 align:middle line:84% The whole idea is that people calm down, 00:47:23.640 --> 00:47:26.040 align:middle line:90% [CHUCKLES] that they don't-- 00:47:26.040 --> 00:47:27.570 align:middle line:90% is there a question? 00:47:27.570 --> 00:47:29.237 align:middle line:84% AUDIENCE: Yeah, just on the last slide-- 00:47:29.237 --> 00:47:31.195 align:middle line:84% RICARDO J. CABALLERO: The previous or this one? 00:47:31.195 --> 00:47:32.640 align:middle line:84% AUDIENCE: Yeah, the previous one. 00:47:32.640 --> 00:47:36.000 align:middle line:84% Is-- [INAUDIBLE] are either of them dependent on the other? 00:47:36.000 --> 00:47:38.452 align:middle line:84% Or are they more just showing the same sort of trend? 00:47:38.452 --> 00:47:39.660 align:middle line:90% RICARDO J. CABALLERO: No, no. 00:47:39.660 --> 00:47:43.170 align:middle line:90% OK, that's a good question. 00:47:43.170 --> 00:47:45.310 align:middle line:90% This is the risk component only. 00:47:45.310 --> 00:47:49.320 align:middle line:84% So this is more independent-- what I'm saying, 00:47:49.320 --> 00:47:52.260 align:middle line:84% when this guy goes up, if nothing else happens, 00:47:52.260 --> 00:47:54.510 align:middle line:84% this will decline because you are discounting things 00:47:54.510 --> 00:47:55.470 align:middle line:90% more heavily. 00:47:55.470 --> 00:47:58.200 align:middle line:84% But it is true that there were some common elements. 00:47:58.200 --> 00:47:59.790 align:middle line:84% There are also common elements, which 00:47:59.790 --> 00:48:03.300 align:middle line:84% is people got very worried about having another regional bank 00:48:03.300 --> 00:48:04.720 align:middle line:90% collapsing and so on. 00:48:04.720 --> 00:48:08.430 align:middle line:84% And so that also created fear about the economy, 00:48:08.430 --> 00:48:10.960 align:middle line:84% which is an independent reason for this to decline. 00:48:10.960 --> 00:48:12.840 align:middle line:84% And normally, in recessions as well, 00:48:12.840 --> 00:48:16.630 align:middle line:90% this risk appetite is lower. 00:48:16.630 --> 00:48:18.910 align:middle line:84% So you're right that it's a common component. 00:48:18.910 --> 00:48:23.310 align:middle line:84% But the point I was highlighting is that this VIX sort of 00:48:23.310 --> 00:48:24.190 align:middle line:90% is a big driver. 00:48:24.190 --> 00:48:28.310 align:middle line:84% It has a big impact on asset prices. 00:48:28.310 --> 00:48:29.960 align:middle line:90% But it's not the cause. 00:48:29.960 --> 00:48:32.670 align:middle line:84% It was an event that caused both. 00:48:32.670 --> 00:48:35.090 align:middle line:84% But the fact that this event came with this big spike 00:48:35.090 --> 00:48:39.530 align:middle line:84% in the VIX meant that the impact on the equity index 00:48:39.530 --> 00:48:42.842 align:middle line:84% was larger than if it had been only news about the economy, 00:48:42.842 --> 00:48:45.050 align:middle line:84% meaning that there was a recession ahead or something 00:48:45.050 --> 00:48:46.370 align:middle line:90% like that. 00:48:46.370 --> 00:48:52.610 align:middle line:84% And let me just finish with the opposite phenomenon. 00:48:52.610 --> 00:48:54.440 align:middle line:84% I was [INAUDIBLE] episodes of fear. 00:48:54.440 --> 00:48:56.600 align:middle line:84% But sometimes markets get very carried 00:48:56.600 --> 00:48:58.340 align:middle line:90% away the opposite direction. 00:48:58.340 --> 00:49:01.607 align:middle line:84% And here I'm showing you examples. 00:49:01.607 --> 00:49:03.440 align:middle line:84% I put together this picture many years back, 00:49:03.440 --> 00:49:06.140 align:middle line:84% and now Deutsche Bank keeps updating it, 00:49:06.140 --> 00:49:10.123 align:middle line:84% which is it shows you some-- it seems that the world needs 00:49:10.123 --> 00:49:10.915 align:middle line:90% a bubble somewhere. 00:49:10.915 --> 00:49:11.690 align:middle line:90% [CHUCKLES] 00:49:11.690 --> 00:49:16.310 align:middle line:84% And here, it shows you several sort of big asset valuations. 00:49:16.310 --> 00:49:18.530 align:middle line:90% Look, 500%. 00:49:18.530 --> 00:49:19.500 align:middle line:90% Here is the Nikkei. 00:49:19.500 --> 00:49:22.000 align:middle line:84% I mean, it was enormous appreciation of the Nikkei. 00:49:22.000 --> 00:49:23.330 align:middle line:90% Here was bitcoin. 00:49:23.330 --> 00:49:24.540 align:middle line:90% Then it collapsed. 00:49:24.540 --> 00:49:26.100 align:middle line:90% They always end up bad. 00:49:26.100 --> 00:49:28.520 align:middle line:84% Whenever you see this big sort of spiking up, 00:49:28.520 --> 00:49:32.340 align:middle line:84% they almost always end up quite poorly. 00:49:32.340 --> 00:49:36.200 align:middle line:84% Now, this is-- it's much more likely that it happens 00:49:36.200 --> 00:49:37.320 align:middle line:90% in equity than in bonds. 00:49:37.320 --> 00:49:39.570 align:middle line:84% In bonds, it cannot happen because there is a terminal 00:49:39.570 --> 00:49:41.400 align:middle line:90% date, a terminal value. 00:49:41.400 --> 00:49:43.920 align:middle line:84% So what happens with these kind of things, 00:49:43.920 --> 00:49:47.162 align:middle line:84% people dream that their value will go to infinity. 00:49:47.162 --> 00:49:49.370 align:middle line:84% And it could because the thing will last to infinity, 00:49:49.370 --> 00:49:50.912 align:middle line:84% and the price could go to infinity. 00:49:50.912 --> 00:49:53.370 align:middle line:84% For a bond, that cannot happen, because there is a terminal 00:49:53.370 --> 00:49:55.495 align:middle line:84% date, and at that date, they going to pay you $100. 00:49:55.495 --> 00:49:56.410 align:middle line:90% So it can't happen. 00:49:56.410 --> 00:50:01.060 align:middle line:84% But for equity, people's imagination can run very wild. 00:50:01.060 --> 00:50:04.380 align:middle line:84% In fact, there is a famous bubble, the South Sea Bubble. 00:50:04.380 --> 00:50:06.850 align:middle line:90% It's a company in the UK. 00:50:06.850 --> 00:50:09.300 align:middle line:84% It's famous for many reasons, but one of them 00:50:09.300 --> 00:50:14.280 align:middle line:84% is that Isaac Newton got involved in this one. 00:50:14.280 --> 00:50:15.700 align:middle line:90% He got carried away. 00:50:15.700 --> 00:50:16.440 align:middle line:90% He sold. 00:50:16.440 --> 00:50:17.880 align:middle line:90% He made a profit. 00:50:17.880 --> 00:50:19.810 align:middle line:90% He sold the shares at 7,000. 00:50:19.810 --> 00:50:22.740 align:middle line:84% He profited 3,500 pounds, which must have been an enormous 00:50:22.740 --> 00:50:24.390 align:middle line:90% amount of money at the time. 00:50:24.390 --> 00:50:26.690 align:middle line:90% Prices kept going up-- 00:50:26.690 --> 00:50:31.070 align:middle line:84% couldn't resist, went back in, ended up losing 20,000 pounds, 00:50:31.070 --> 00:50:32.580 align:middle line:84% which must have been a lot of money. 00:50:32.580 --> 00:50:34.940 align:middle line:84% So he famously said, "I can calculate the motions 00:50:34.940 --> 00:50:37.690 align:middle line:84% of the heavenly bodies, but not the madness of people." 00:50:37.690 --> 00:50:39.290 align:middle line:84% This is all about expectations, OK? 00:50:39.290 --> 00:50:41.860 align:middle line:90% [CHUCKLES] Let me stop here. 00:50:41.860 --> 00:50:54.000 align:middle line:90%