Business Cycles

Chapter 15

Stabilization Theory

Chapter 16

Equity Markets

Chapter 21

Corporate Profits

We find that corporate profits are strongly pro-cyclical and volatile.

When the economy is doing well, corporations tend to earn high real profits.

Corporate profits fluctuate far more than the economy as a whole.

HK Corporate Earnings & the Business Cycle

-.5

-.4

-.3

-.2

-.1

.0

.1

.2

.3

.4

86 88 90 92 94 96 98 00 02

Real Corporate Earnings Real GDP

% D

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Tre

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Objectives

Use the Gordon model to characterize dividend yields.

Analyze the characteristics of business cycles Use the AS-AD model to understand the

events that drive short and medium run fluctuations and stabilization policy.

Use the CAPM model to characterize expected returns of individual stocks (if time)

Equity Markets

Chapter 21

Stocks for the Long Run Over time, stocks pay consistently higher

returns than other types of financial investment like bonds or gold.

Stocks can also be risky. For relatively long periods, stocks can under-perform bonds or even lose money.

What are stocks and where does this risk come from?

Equities (or shares or stocks) Paper asset reflecting part ownership of company and the future stream of income that it earns.

Stocks

Equities like common or ordinary stocks are a claim to the profits of a corporation

Stocks have no maturity date. Firms may buy back stock at market prices as they choose.

Stock owners receive periodic but not fixed payments called dividends. Dividends reflect the profitability of the business and are not known in advance.

Stock owners are the owners of the firms. Holders of shares vote for the directors of firms on a one share-one vote basis.

Stock owners are the residual claimants to a firms income meaning a firm that goes out of business must repay all debt before stock owners get any income.

Stock owners enjoy limited liability. Unlike the owners of private firms, stock owners cannot lose more than the value of their stock.

Stock Markets in Hong Kong

Stocks in HK are traded at the HK Stock Exchange.

Stock Index: A stock index is a price aggregate for stocks. Calculate the weighted sum of the prices of a set of stocks which represent an average of the market.

Hang Seng Index is a weighted average of prices of the equities of major (“blue chip”, “large cap”) stocks in HK

Economic Function of the Stock Market

Stock markets can be an important means for companies to raise funds to finance investment.

Stock markets are a liquid market in which assets can be traded.• Stock markets allow savers to efficiently

diversify assets.

• Stock markets allow for efficient corporate ownership of assets.

Stocks and Business Cycles The payoff to stocks represent a share of

the profits of firms in an economy. In general terms, as an asset class,

stocks will generate payments that reflect the profits generated by the economy.

Profits which are a share of income are volatile over the business cycle.

Risk of stocks may also vary over business cycles.

Stock Returns

Gross returns on any asset are the payoff divided by the initial price.

Stocks pay-off of stocks is dividend plus price next period

Gross Return for Stocks Capital Gain + Dividend Yield

1 1

1 11

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Required Return

Define req as the return required by investors to get them to hold a share of stock.

Stocks may be volatile and risky. Typically required returns will be equal to the risk free interest rate plus a risk premium req = rrf + heq

Fundamental Value of Stock

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Dividend Yields: Gordon Equation Assume that dividends grow at a constant rate g . This implies

Dt+j = (1+g)j Dt

If x < 1,

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Determinants of the Dividend Yield

The dividend yield plus capital gains is like an interest rate earned on stocks which in a free market must be equal to interest rates on other assets (adjusted for the risk of owning stocks).

In the long run, the growth rate in stock prices (capital gains) will be equal to growth rate of dividends which will be equal to the growth rate of corporate profits which will be equal to the growth rate of the economy.

What determines the risk premium on individual stocks?

FAQ

What are the implications of the Gordon Growth model for stock prices?

Relative to current dividends, stock prices will be high when• expected growth of dividends is high.

• interest rates are low (the return on other assets are low.

• the risk premium is low.. Is the Gordon Growth Model a nominal model or a

real model? It works either way.

Business Cycles

Chapter 15

Business Cycles

Business cycles are medium term fluctuations in real output and other variables.

Business cycles are characterized by co-movement. All expenditure, production and income categories move with business cycle.

Degree of business cycle co-movement varies across sectors which is important for asset pricing.

Recessions and Booms

Business cycle positions are sometimes characterized as booms and recessions.

These names have many definitions but a boom occurs roughly when real output is above the trend growth path (detrended output is positive). A recession occurs roughly when real output is below trend growth.

HK Booms & Recessions

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-.08

-.04

.00

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1975 1980 1985 1990 1995 2000

Hong Kong GDP

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fro

m T

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d

Oil Shocks

Handover Talks

6-4 Incident

Asian Crisis

Business Cycles & Co-movement

Business cycles are fluctuations in the economy as a whole.

Different sub-categories of GDP tend to co-move with business cycles though to different degree.

Business cycles tend to co-move across countries though not as strongly as within countries.

Business Cycles & Sub-Categories

Expenditure. Consumption and Investment co-move with output. Investment is more volatile than consumption. Consumer durables are most volatile part of consumption.

Production – Production sectors co-move with business cycles. Manufacturing & Construction most volatile. Services least volatile.

Income – Worker Compensation & Capital Income are both pro-cyclical. Capital Income tends to be more volatile.

Hong Kong Expenditure Cycles

-.15

-.10

-.05

.00

.05

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.15

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1975 1980 1985 1990 1995 2000

GDPHousehold ConsumptionFixed Investment

AS-AD Framework Microeconomists use supply/demand

framework for thinking about markets. Macroeconomists use Aggregate Supply/

Aggregate Demand as the central framework for thinking about business cycles.

AS/AD framework examines the relationship between the level of output (real GDP) and the aggregate price level (GDP deflator).

We use the AS/AD to show how different events will affect output & prices in the medium and long run.

Long Run Aggregate Supply

Central pillar of AS-AD framework is the assumption that there is no long run relationship between prices and firms willingness to produce goods.

In the long run, output may change but it is not affected by nominal level of the economy.

Long run AS is decided outside the AS-AD framework and is thus, exogenous.

LRASP

Y

YLR

Why is Supply Exogenous in the Long Run?

Output is determined by labor (workers), capital (structures & equipment) and technology.

These factors are determined in the long run by relative prices like the real wage rate (dollar wages divided by the price level) and the real interest rate which are assumed to be exogenous to the nominal level of the economy in the long run.

Short Run Aggregate Supply In the short-run, there is thought to be a

positive relationship between the aggregate price level and firms willingness to supply goods.

Central element in this story is that dollar wages that firms pay workers are determined by formal and informal wage contracts.

If wages are fixed, a rise in the price level reduces the relative cost of labor for firms. Firms hire more workers, work their existing employees longer hours and produce more output.

LRASP

Y

YLR

SRAS

PE

FAQ

Q: Why is the SRAS upward sloping?

A: Given wages, an increase in prices reduces real wages for firms. Firms increase employment and production.

Q: What shifts the SRAS curve?

A: If wages rise the real wage rate will increase at any price level. A rise in the real wage causes firms to cut back on employment and production.

LRAS

P

Y

YLR

SRAS

PE

SRAS’Wages ↑

Expected Price Level

Q: What is PE?A: PE is where SRAS crosses LRAS

Q: What is the significance of PE? A: PE is the expected price level. If the actual price were equal to the expected price level, real wages would be as expected and output would be at its long run level.

Q: How does PE affect the business cycle. A: When actual prices are above PE , price expectations will tend to move upward over time. When wages are renegotiated, they change in the same direction as price expectations. When

The aggregate demand curve maps a negative relationship between the price level and demand for goods.

The AD curve embodies the negative relationship between the nominal price level and the amount of goods that will want to buy.

The underlying basis of this is a fixed monetary policy

Q: Why is the AD curve downward sloping?

A: Under a Fixed Exchange rate, a rise in prices causes a real exchange rate appreciation reducing net export demand.

FAQ

Q: Why is the AD curve downward sloping?A: It depends on the exact monetary policy.

1. In most large economies, interest rate targets rise when prices rise. This reduces investment & consumption and an exchange rate appreciation (net exports decline).

2. If central bank sets a fixed level of money supply, a rise in prices reduces the purchasing power of cash held by shoppers. They withdraw funds from banks. In order to meet their own liquidity needs, banks raise interest rates to attract deposits. The interest rate rise in reduces consumption & investment spending and an exchange rate appreciation (net exports decline).

P

Y

YLR

AD

What shifts the AD curve?:

Event Category AD

1. Stock Market/Real Estate Prices Fall C ↓, I↓ ←

2. Expectation of Future Income Falls

C ↓ ←

3. Uncertainty & Precautionary Savings Rise

C ↓, ←

4. Expected Yt+1/Kt+1 Falls I ↓ ←

5. Foreign Interest Rates Rise C ↓ , I ↓ ←

6. Government Spending Fall G ↓ ←

7. Taxes Rise C ↓ ←

What shifts the AD curve? Pt. 2

Event Category AD

8. Foreign Economy Contracts NX ↓ ←

9. Devaluation of Currency NX↑ →

10. Tariffs Rise NX↑, →

11. Currency Risk Premium Rises

C,I ↓ ←

Spillovers

A decrease in demand will tend to decrease the level of output and production which will decrease household income which will put downward pressure on consumption.

A decrease in demand will reduce the level of output per unit of capital so this will tend to diminish profit maximizing level of capital putting downward pressure on investment.

A decrease in demand will reduce import demand partially offsetting the multiplier effect on consumption.

AS-AD

The AS-AD model determines the position of nominal prices and real output over time.

Equilibrium output and price level are defined as the intersection between SRAS and AD.

LRAS exists in the background exerting a gravitational pull.

P

Y

YLR

AD

[P*,Y*]

SRAS

Gravitational Pull:

Whenever the AD curve and the SRAS cross each other away from the LRAS curve, P* will not equal

PE. If the prices that workers and firms observe (P*)

are different than the prices they expected when they negotiated labor contracts (PE), real wages are different than long-term levels. • If P* > PE real wages are lower than long-term

• If P* < PE real wages are higher than long-term

Gravitational Pull Cont.

If actual prices (P*) are different from expected prices (PE), expectations will be updated for future labor contracts.

If P* > PE, PE will rise over time and workers will demand higher wages. This will cause the SRAS curve to shift upward as firms charge higher prices for their output. Wages rise until P* = YE and Y* = YLR.

If P* > PE, PE will fall over time and firms will demand workers take pay cuts. This will cause the SRAS curve to shift downward. Wages rise until P* = PE and Y* = YLR.

P

Y

YLR

AD

[P*,Y*]

SRAS

SRAS’

Business Cycles as Shocks

Business Cycles are thought of as being driven by “random” events which destabilize the economy from its long-term path and set in motion a train in events.

These events are separated into those that affect demand (exogenously shift the demand curve) and those that affect supply (exogenously shift the supply curve).

AS-AD theory is set up to examine demand driven shocks.

• Contractionary Shock & Recession

P

Y

YLR

AD

[P*,Y*]

SRAS

[P**,Y**]

AD’

Short Run

Some Event causes a contraction in Aggregate Demand.

Demand for Goods falls as do equilibrium market prices. This increases real wages and reduces demand for labor. Unemployment rises and production decreases.

Medium: Wage Renegotiation

P

Y

YLR

SRAS’

[P***,Y***]PE

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SRAS

Medium Run

After shift in demand curve, P** < PE. When employers have a chance to renegotiate salaries, they will offer lower wages.

Reduced wage costs will reduce production costs. Reduced production costs will reduce the price charged by firms at every level of production.

This is equivalent to a downward shift in SRAS curve.

Return to Long Run

P

Y

YLR

AD’

SRAS’’

PE[P****, Y****]

Return to Long Run

Wages continue to be bid down as long as prices are below expected prices.

This is equivalent to saying that the SRAS continues to shift downward until it crosses the new AD curve where the AD curve crosses the LRAS curve.

Demand Driven Recessions

Recession Caused By Contraction in Demand is Characterized by • Lower than Expected Inflation (in some cases even

deflation)

• High Unemployment

• High Real Wages Boom Caused By Expansion in Demand is

Characterized By • Higher than Expected Inflation

• Low Unemployment

• Low Real Wages.

Real Wages & Business Cycles in Hong Kong

1987/88 1989/90 1991/92 1993/94 1995/96 1997/98 1999/00 2001/02

120

115

110

105

100

95

90

HK: Real Salary Index (A): All IndustriesJun 1995=100

Phillips Curve & Inflation Relationship between

Higher or Lower than expected Inflation and higher or lower than average unemployment is called the Phillips curve after Kiwi economist A.W. Philips.

When inflation is faster than expected inflation, inflation will be faster than nominal wage growth, real wages will be decreasing. Demand for workers will be high and unemployment will be low.

Phillips Curve

π-Inflation Rate π Expected Inflation Rate ur-Unemployment Rate urNR – Natural Rate of

Unemployment

)( tNRE

tt ururA

Natural Rate of Unemployment

The unemployment rate is the ratio of adults looking for work relative to the sum of the number of adults working and looking for work.

The natural rate of unemployment is the unemployment rate that will occur hen economy is at its long-term level of output YLR due to standard turnover of jobs.

Natural rate of unemployment is sometimes called NAIRU – Non-accelerating Inflation Rate of Unemployment (for reasons which will become apparent).

Uses of the Phillips Curve Inflation expectations and natural rate cannot be

observed. Moreover, Phillips curve ignores inflation from supply side

factors like energy prices. When combined with a theory about the formation of

expectations, Phillips Curve can be used to calculate additional unemployment that results from disinflationary paths induced by policy.

For example, HK is experiencing a recession and deflation. How might unemployment be reduced if the government used (monetary or fiscal policy) to increase the inflationary path.

Adaptive Expectations

Simplest theory of inflationary expectations assumes that people respond to past events.

In this case, unemployment is a function of inflation deceleration.

1 tEt

)(1 tNR

tt ururA

Example

Government foresees a deflationary path of -3% this year, -4% next year, and -5% thereafter. Government can use policy to change this to inflation of -2%, 1% and 3% respectively.

Assume A = .5 and urNR =4%, what will be the affect of such a policy on unemployment.

Example

π πE ur π πE ur

2002 -3% 0 5.5% -2% 0 5%

2003 -4% -3% 4.5% 1% -2% 2.5%

2004 -5% -4% 4.5% 3% 1% 3%

2005 -5% -5% 4% 3% 3% 4%

2006 -5% -5% 4% 3% 3% 4%

Insights

More quickly that inflation expectations (and wages) respond to inflation, the less will unemployment respond.

Unemployment effects of inflation are temporary.

Only way for government to permanently reduce employment permanently is to induce a permanently accelerating inflation path.

Supply Shocks

Exogenous events like energy prices or natural disasters may directly effect the production costs of firms.

Such events can be modeled within the AS-AD framework.

An event that causes a temporary rise in production cost is modeled as an exogenous shift upward in the SRAS curve.

This will lead to a rise in prices and a reduction in output.

• Contractionary Supply Shock & Stagflation

P

Y

YLR

AD

[P*,Y*]

SRAS

SRAS’

[P**,Y**]

AD’

Theory of Risk

The fundamental insight of the theory of finance is that the risk of an asset is not measured by the volatility of the assets returns, but by the amount that it adds volatility to your portfolio.

A well diversified portfolio can reduce the average risk of the assets in the portfolio.

Example: Coin Flipping Stocks

Consider a portfolio with a 1 million shares of Heads or Tails Inc. At the end of the year, HoT will flip a coin. If Heads comes up, the company will pay a dividend of a dollar per share. If tails comes up, the company will pay 0. Either way, the company will close down. Present value of the expected dividend is $.5 million.

However, price that a portfolio investor will pay for this portfolio should be considerably less than $.5 million because of the high risk of the portfolio.

Well Diversified Portfolio

Consider a portfolio of 1 million shares of stocks in 1 million different coin-flipping companies.

At the end of the year, each company will independently flip a coin (for a total of 1 million coin flips). If heads come up, they will pay a dollar. If tails come up, they will pay nothing.

Each individual share has the same risk characteristics as share of Heads or Tails Inc. Expected PV = $.5 Million

However, Law of Large Numbers says that if you flip a coin 1 million times, there is an extremely high probability that you will come very close to getting .5 million heads.

Perfectly diversified portfolio of independent coin-flipping stocks has very low risk.

Comovement as Risk

The individual shares in the first portfolio have the same properties as the shares in the second portfolio, but the second portfolio has more risk overall. Why?

The reason is the pay-offs of the shares in the first portfolio have a strong mutual covariance (i.e. statistical co-movement). The shares in the second portfolio have zero covariance.

A well-diversified portfolio will be composed of a variety of stocks with as little co-movement as possible.

Portfolio Risk A stock will add more volatility to your

portfolio if its return has a high covariance with the assets in your portfolio than a stock whose return is independent of the assets.

A stock that is negatively correlated with your portfolio can reduce the volatility of your portfolio.

Is it possible to construct a risk-free portfolio of stocks in the real world? No. Why not? Systematic Risk.

Systematic Risk

Stock returns in a market tend to move together. Most companies tend to have common movements in

returns due to business cycles. Common or systematic risk cannot be diversified away. All firms have idiosyncratic risk which is independent of

systematic risk. This risk can be diversified away. Different firms have different exposure to systematic

risk. Firms whose returns drop especially sharply when the market as a whole drops, have larger exposure to market risk. Adding these stocks to your portfolio adds proportionately more to the volatility to your portfolio.

Capital Asset Pricing Model The CAPM takes the point of view that the risk

premium for an individual stock j demanded by the market as a whole are a function of the extra volatility added to a diversified portfolio by the individual stock.

The degree to which an individual stock adds to the volatility of a diversified portfolio depends on the co-movement of its return with the overall market return.

Stocks which have greater exposure to systematic risk display greater co-movement with the market portfolio.

The degree to which a stock adds to the risk of a well-diversified portfolio is measured by its beta coefficient

• rf : Risk-free return

• Rm: Return on Market Portfolio (Return on a Broad Index like Hang Seng)

• Rj : Return on Stock j

: Correlation of Excess Returns on Stock j (Rj- rf) with the excess returns on market portfolio (Rm- rf)

m : Standard Deviation of Excess Returns on Market Portfolio

j : Standard Deviation of Excess Returns on Stock j

Model of Equity Premium

Beta is the product of the correlation of the excess returns on a stock with the excess returns on a market portfolio and the relative volatility of the stocks returns.

A stocks equity premium is proportional to its beta

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j

ff

em

fej hrRrR )(

CAPM and Dividend Yield

Stock is forecast to have constant dividend growth of 4%. The risk-free interest rate is 5%. The average market return is 10%. stock has a beta of 1.2.

rj = .05 + 1.2·(.10-.05) = .11 Pt = Dt+1· 1/(.11-.04)

07.04.11.1

t

t

P

D

Implications for Macroeconomics

For asset pricing, it is not possible to price individual stocks based on microeconomic information. We must understand how returns co-move with the aggregate market.

Business cycles are a key source of systemic volatility.

We can understand a company’s exposure to market risk by understanding its exposure to business cycles.

Equity Premium Puzzle

Why are stock returns so much higher than bond returns?

Equity owners (unlike bond owners or workers) absorb the full risk of economic fluctuations.

Much of the risk of the overall wealth portfolios of individual savers comes from equity risk. Equity as an asset class has a high beta with the overall wealth portfolio and requires high returns.

No economic model, however, has satisfactorily explained why the equity premium puzzle is as high as it is.

Equity Premium in Long Run Perspective

Consider two 35 year old investors. In 1974, each has $100 dollars two invest. One puts the money into the HK stock market and keeps it there. The other puts his money into bonds and continuously rolls over his funds.

How do the portfolios of these investors progress through time?

At first Mr. Stocks does not do so well, but…

Portfolios

0

50

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1972 1977 1982

HK

Do

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Stocks

Bonds

Portfolios

0

500

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1972 1977 1982 1987 1992 1997

Year

Do

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Bonds