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Author(s): Brian Kettell Series: Quantitative finance series Publisher: Butterworth-Heinemann, Year: 2002 ISBN: 0750653841,9780750653848,9781429484299 Pages : 375 Language : English Size : 831 Kb Extension : pdf

PREFACE xi 1. WHAT DO YOU NEED TO KNOW ABOUT MACROECONOMICS TO MAKE SENSE OF FINANCIAL MARKET VOLATILITY? 1 The big picture 2 Financial markets and the economy 5 Gross national product and gross domestic product 8 Monetarism and financial markets 8 The quantity theory of money – the basis of monetarism 9 How money affects the economy – the transmission mechanism 12 The modern quantity theory – modern monetarism 15 Monetarism and Federal Reserve operating targets from 1970 to the present 18 The Non-Accelerating Inflation Rate of Unemployment (NAIRU) 28 2. THE TIME VALUE OF MONEY: THE KEY TO THE VALUATION OF FINANCIAL MARKETS 33 Future values – compounding 33 Present values – discounting 34 Bond and stock valuation 36 Simple interest and compound interest 41 Nominal and effective rates of interest 45 3. THE TERM STRUCTURE OF INTEREST RATES AND FINANCIAL MARKETS 47 Functions of interest rates 47 Determination of interest rates, demand and supply of funds 48 International factors affecting interest rates 53 Price and yield – a key relationship 54 The term structure of interest rates 56 Determination of forward interest rates 58 The yield curve 59 Unbiased expectations theory 59 Liquidity preference theory 62 The market segmentation theory 66 The preferred habitat theory 66 4. HOW CAN INVESTORS FORECAST THE BEHAVIOUR OF FINANCIAL MARKETS? THE ROLE OF BUSINESS CYCLES 71 The cyclical behaviour of economic variables: direction and timing 75 The stages of the business cycle 76 The role of inventories in recessions 81 The business cycle and monetary policy 82 How does monetary policy affect the economy? 83 Fundamental analysis, the business cycle, and financial markets 85 The NBER and business cycles 87 How do you identify a recession? 90 The American business cycle: the historical record 91 The Non-Accelerating Inflation Rate of Unemployment (NAIRU) – a new target for the Federal Reserve 95 What is the future of the business cycle? 100 5. WHICH US ECONOMIC INDICATORS REALLY MOVE THE FINANCIAL MARKETS? 103 Gross national product and gross domestic product 103 GDP deflator 105 Producer price index (PPI) 107 The index of industrial production 109 Capacity utilization rate 110 Commodity prices 111 Crude oil prices 111 Food prices 113 Commodity price indicators: a checklist 114 Consumer price index (CPI) 116 Average hourly earnings 118 The employment cost index (ECI) 119 Index of leading indicators (LEI) 121 Vendor deliveries index 123 6. CONSUMER EXPENDITURE, INVESTMENT, GOVERNMENT SPENDING AND FOREIGN TRADE: THE BIG PICTURE 125 Car sales 126 The employment report 128 The quit rate 132 Retail sales 133 Personal income and consumer expenditure 135 Consumer instalment credit 137 Investment spending, government spending and foreign trade 138 Residential fixed investment 140 Non-residential fixed investment 143 Inventory investment 146 Government spending and taxation 148 Budget deficits and financial markets 153 Foreign trade 156 7. SO HOW DO CONSUMER CONFIDENCE AND CONSUMER SENTIMENT INDICATORS HELP IN INTERPRETING FINANCIAL MARKET VOLATILITY? 159 Michigan index of consumer sentiment (ICS) 160 Conference board consumer confidence index 161 National association of purchasing managers index (NAPM) 164 Business outlook survey of the Philadelphia Federal Reserve 168 Help-wanted advertising index 169 Sindlinger household liquidity index 171 8. THE GLOBAL FOREIGN EXCHANGE RATE SYSTEM AND THE ‘EUROIZATION’ OF THE CURRENCY MARKETS 174 What is the ideal exchange rate system that a country should adopt? 174 Dollarization and the choice of an exchange rate regime 179 Why do currencies face speculative attacks? 182 The IMF exchange rate arrangements 185 What is the current worldwide exchange rate system? (October 2001) 187 The ‘Euroization’ of the foreign exchange market 193 The European Exchange Rate Mechanism: ERM II 194 9. WHY ARE EXCHANGE RATES SO VOLATILE? THE FUNDAMENTAL AND THE ASSET MARKET APPROACH 203 Exchange rate determination over the long term: the fundamental approach 203 Determination of exchange rates in the short run: the asset market approach 210 Why do exchange rates change? 215 Why are exchange rates so volatile? 219 10. HOW CAN INVESTORS PREDICT THE DIRECTION OF US INTEREST RATES? WHAT DO ‘FED WATCHERS’ WATCH? 222 Rule 1: remember the central role of nominal/real GDP quarterly growth 222 Rule 2: track the yield curve if you want to predict business cycle turning points 225 Rule 3: watch what the Fed watches – not what you think it should watch 229 Rule 4: keep an eye on the 3-month euro–dollar futures contract 231 Rule 5: use Taylor’s rule as a guide to changes in Federal Reserve policy 232 Rule 6: pay attention to what the Federal Reserve does – not what it says 234 Rule 7: view potential Federal Reserve policy shifts as a reaction to, rather than a cause of, undesired economic/monetary conditions 234 Rule 8: remember that ultimately the Federal Reserve is a creature of Congress 235 Rule 9: follow the trends in FOMC directives: how to interpret Fed speak? 236 Rule 10: fears of inflation provoke faster changes in monetary policy than do fears of unemployment 238 11. DERIVATIVES: WHAT DO YOU NEED TO KNOW ABOUT ECONOMICS TO UNDERSTAND THEIR ROLE IN FINANCIAL MARKETS? 240 What are derivatives? 240 Where did derivatives come from? 241 Some terminology 241 What is an option? 242 Exchange-traded versus over-the-counter (OTC) options 244 Where do option prices come from? 245 Arbitrage 245 Probability distributions 248 Who are the market participants in the derivatives market? 251 The arbitrageur’s role and the pricing of futures markets 253 What are the factors influencing the price of futures? 254 Futures pricing 255 What is basis? 257 Spot versus forward arbitrage 258 What are forward market contracts? 259 What are futures contracts? 260 How are options priced? 262 The binomial model 263 What determines the value of call options? 267 What is the profit profile for a call option? 270 Put options 272 What are the determinants of the value of a call option? 275 Black–Scholes model 278 12. THE NEW ECONOMIC PARADIGM: HOW DOES IT AFFECT THE VALUATION OF FINANCIAL MARKETS? 281 The new economy defined 281 So what is the new economic paradigm? 288 The triangle model 291 The new paradigm and the price earnings ratio 293 13. BUBBLEOLOGY AND FINANCIAL MARKETS 296 Introduction 296 The bubble terminology 297 The role of expectations in analysing bubbles 298 Bubbles and the formation of expectations 299 Bubbles and the efficient market hypothesis 300 Rational bubbles 302 Some bubbles in history 304 Speculative bubbles theory 309 Rational speculative bubbles 311 The ‘bubble premium’ 312 APPENDIX A. Diffusion indexes: their construction and interpretation 315 APPENDIX B. The construction and interpretation of price indices 318 APPENDIX C. Title, announcement time, and reporting entities for macroeconomic announcements 323 APPENDIX D. Consumer and business confidence surveys 324 APPENDIX E. Useful web addresses 326 BIBLIOGRAPHY 335 INDEX 345

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