Economic Indicators

Economics Joke:
• There are only two economists in the
world know where the economy is going.
And they disagree!

If you were an economist, this would be

hilarious! For the rest of us, not so funny.
But, it tells us one thing: economics is
unpredictable. We can only guess at what is
happening.
 Economic Indicators
• Predicting the business cycle is tricky.
Often the economy does not do what
economists expect. Looking at lots of
indicators give them a feel for what is
going on and an idea of how to prepare for
the future.
• Def. Trends in the economy which tell
economists where the business cycle is
going and where it has been.
Three Types of Indicators
Leading Indicators
(where the cycle is going)
Coincident Indicators
(where the cycle is now)
Lagging Indicators
(where the cycle has been)
 Leading Indicators
• Def. Economic activity that happens prior
to (before) a change in the economic
cycle.

• These are predictors of where the

economy is going next: Expansion or
contraction.
 Leading Economic Indicators
Indicator Significance
• Average weekly • Reflect layoffs and
initial claims for new hires (more
unemployment unemployment,
contraction. Less
unemployment,
expansion)

• Reflect Investor
• Stock Prices attitudes (rise
=expansion, fall=
contraction)
 Leading Economic Indicators
(cont.)
Indicator Significance
• Interest Rates • Rates are lowered if
a recession is
coming, raised if
expansion.

• Index of consumer • Reflects changes in

confidence (a survey consumer attitudes
of how people feel about the future.
about the economy)
 Coincident Indicators
• Def. Information that is used to measure
economic change as it happens.

1. Total industrial production

2. Total industrial sales
3. Personal Income
4. Number of employees on industrial
payroll
 Lagging Indicators
• Def. Economic activity that change after
the business cycle expands or contracts.

1. Interest rates banks charge on loans

2. Amount of money owed
 Unemployment
Last Unit: 16+, not institutionalized,
temporarily laid off, and looking for work.

• Unemployment Rate: def. the percentage

of the labor force unemployed and actively
looking for work.
(remember, we don’t count people not
looking for work, “hidden unemployment”)
 Types of Unemployment
• Frictional Unemployment
• Cyclical Unemployment
• Seasonal Unemployment
• Structural Unemployment
 Frictional Unemployment
• Def. People who are between jobs or just
entering the workforce
– Ex. High School/College graduates, people
changing careers, etc.
• This is a normal kind of unemployment.
 Cyclical Unemployment
• Def. Unemployment caused by changes in
the business cycle during a contraction
phase. Businesses lay off workers and the
unemployment rate increases. These
workers will find work when the business
cycle moves to an expansion phase. This
is a normal form of unemployment.
 Seasonal Unemployment
• Def. Unemployment caused by natural
changes in weather/season.
– Ex. Farming, construction, Darien Lake
workers, snow plowers, landscapers.
• When the season changes, they will get
their jobs back. Another normal form of
unemployment.
 Structural Unemployment
• Def. Changes in the economy that makes
certain workers obsolete. Their skills are
no longer needed.
– Ex. Business owners move the factory to
another country (outsourcing), robots replace
assembly line workers.
• This is a bad form of unemployment.
These workers have a difficult time finding
new jobs because their skills are not
needed. Need to be re-trained for the new
job market
 Inflation
• Def. A general rise in prices due to a
decrease in the value of money.
– Ex. 5 years ago, a can of soda from a
machine cost $.75. Today it is $1.00 or more.
• Inflation is natural and even necessary.
But when inflation increases too quickly, it
has dangerous effects on the economy.
(i.e. people cannot afford to purchase
needs and wants)
 Causes of Inflation
• Demand-Pull Inflation:
– When the demand for products exceeds the
supply, prices rise. Too many dollars, too few
goods. This is a natural result of expansion of
the Business Cycle.
• Cost-Push Inflation:
– When scarcity causes the cost of production
to increase, prices rise. Ex. Gas prices
increase the cost of fuel for airplanes, so
ticket prices increase
 Effects of Inflation
1. Price of goods rise (ex. Can of soda)
2. Money buys less
3. Standard of living declines (ex. More and
more households have two people
working to make ends meet)
4. People who save money are hurt (if
inflation is higher than investment
returns, losing money!)
 Effects of Inflation cont.
• Inflation hits people with fixed incomes
(people with a set monthly income that will
not increase) the hardest.
– Ex. Retirees and disabled people. Their social
security checks, pensions, or investments are
limited and do not increase even when prices
increase.
Investments: Analysis and
Behavior

Dr. Bhupendra Kumar

Dr. Bhupendra Kumar Galgotias University

 Characteristics of Bonds
• Bonds: debt securities that pay a rate of interest based upon
the face amount or par value of the bond.

n Price changes as market interest

changes

n Interest payments are commonly

semiannual

n Bond investors receive full face

amount when bonds mature

n Zero coupon bonds – no periodic

payment (no interest reinvestment rate)
¨ Originally sold at a discount
 Bond Pricing
• Present of the Bond = Present value of interest payments +
Present Value of Principal

PV of Annuity (pmt, I, N) + PV (FV, I, N)

N
PMT FV
PV = å +
t = 1 (1 + i) (1 + i) N
t

Where N = time to maturity

i= market interest rate
PMT = semiannual interest payment
FV = face value
When the market interest rate is less than the bond’s coupon rate, price is greater
than the face value (Sold at premium, bonds 2,4).
When the market interest rate greater than coupon rate, bond is sold at discount
(bonds 1, 3, 5).
 Bond price calculation
• The bond pays $25 semiannual coupon payment
• Maturity: three years and one month
• Market interest rate: 6% (APR)
Solution:

– Using financial calculator

N = 2 x 3 1/12 = 6.167 yrs
I/Y = 6% /2 = 3%
PMT = 25
FV = $1,000
PV = $972.23
 Callable Bonds
• Call provision allows the issuer to repay the
investors’ principal early.

• Issuers call the bond when they want to

refinance their debt at the lower interest rate

• Call price is commonly the face value plus one

year of interest payments.

• Call protection: amount of the time before the

bond becomes callable.
 Expected yield Calculation

• Yield to maturity (or yield to call): expected total

rate of return if investor were to buy and hold the
bond until maturity or until call date.
– Internal rate of return of the bond that equates the
present value of the cash flow with the price of the
bond.

• Solve for I in
Bond price = PV of Annuity (pmt, I, N) + PV (FV , I, N)
• Example:
The bond pays $25 every six months.
The bond matures in 3 years and one month.
Price of the bond is $972.23.
What is the bond’s yield to maturity?

Solution:

Using financial calculator

N= 6.167 PV = -972.23 PMT= 25 FV=1,000
i 3% (or 6% annually)
 Interest rate risk
• Bond prices are sensitive to the
market interest rate

• If interest rates rise, the market

value of bonds fall in order to
compete with newly issued bonds
with higher coupon rates.

• Sensitivity to the interest rate

chance become more severe for
longer term bonds

• Percentage rise in price is not

symmetric with percentage decline.
 An Illustration of Interest-rate Risk for Treasury Securities With a 6% Coupon Selling at
Table 15.3 Par of $1,000

Term to Decline in bond value following Rise in bond value following

Maturity an increase in rates a decrease in rates

Bond Type (years) 1% 2% 3% -1% -2% -3%

Treasury bill Six months 0% 0% 0% 0% 0% 0%

Treasury note 2 -1.84% -3.63% -5.38% 1.88% 3.81% 5.78%

Treasury note 5 -4.16% -8.11% -11.87% 4.38% 8.98% 13.83%

Treasury bond 10 -7.11% -13.59% -19.51% 7.79% 16.35% 25.75%

Treasury bond 20 -10.68% -19.79% -27.60% 12.55% 27.36% 44.87%

Treasury bond 30 -12.47% -22.62% -30.96% 15.45% 34.76% 59.07%

 Figure 15.1 Market Interest Rates for 30-year U.S. Treasury Bonds, 1995-present

7.5

6 .5

5.5

4 .5

3 .5

M o nt h- y e a r
 Term structure of interest rate

• Yield curve: line describing the relationship between

yield to maturity and term to maturity

– Liquidity preference hypothesis: long term yield is greater

because investors prefer the liquidity in short term issues.
– Segmented market hypothesis: yield curve reflects the hedging
and maturity needs of institutional investors
 Duration
• Term to maturity is an imperfect measure of
bond risk because it ignores the valuation effects
of differences in coupon rate and principal
payment schedule
• Duration: an estimate of economic life of a bond
measured by the weighted average time to
receipt of cash flows
– The shorter the duration, the less sensitive is a bond’s
price to fluctuations
 Duration (or Maculay duration) calculation
T
t ´ Cash Payment t T
t ´ Cash Payment t
å (1 + Yield )
t =1
tj å (1 + Yield )
t =1
tj
Duration = =
Cash Payment
T
Bond Price
å (1 + Yield )
t =1
tj
t

Example: Calculate duration for a 7.5% bond with 5

years to maturity and a yield of 6.75%.

æ 0.5 ´ $37.50 1 ´ $37.50 1.5 ´ $37.50 4.5 ´ $37.50 5 ´ ($37.50 + $1,000) ö

Duration = ç 0.5
+ + +  + + ÷ ÷ $1,031.40 = 4.3 years
è 1.0675 1.06751 1.06751.5 1.06754.5 1.06755 ø
 Duration
Modified duration =
æ Yield ö
1 + çç ÷÷
è Coupon Payments per Year ø

– Direct estimate of the percentage change in bond

price for each percentage point change in the market
interest rate.

% change in bond price = – 1 × % Yield change × modified

duration

Example: given that duration is 4.3 yrs, if interest rates

fall by 0.5% what is the change in the bond price?
Modified duration = 4.3 / (1.0337) = 4.16

% change in price= -1× (–0.5%)×4.16 = 2.08%

 Convexity
• Convexity measures the sensitivity of modified duration
to changes in interest rate (the rate of “acceleration” in
bond price changes)
– The degree of bend in the price–yield curve
Figure 15.3 The Price-yield Curve for a 30-year 6% Bond is More Convex to the Origin than the
Price-yield Curve for a 5-year 6% Bond

2,500

2,000

1,500
Bond Price ($)

30-year 6% Bond
5-year 6% Bond
1,000

500

0
0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%
Yield to maturity
 Bond pricing using convexity and
duration
T
(t 2
+ t )´ Cash Paymentt
åt =1 (1 + Yield ) tj
Convexity =
Bond Price ´ (1 + Yield )
2

• % bond price change = – 1 × % Yield change × modified

duration + ½ × convexity × (Yield change)2
• Using both duration and convexity allows for a more
accurate estimation
 • Example:

Compute the convexity for the 7.5% bond with 5 years to maturity
and a yield of 6.75%.

( ) ( )
æ 0.5 2 + 0.5 ´ $37.50 12 + 1 ´ $37.50
çç + ++
( ) +
( )
4.5 2 + 4.5 ´ $37.50 52 + 5 ´ ($37.50 + $1,000) ö
÷÷
0.5 1 4.5 5
1.0675 1 .0675 1.0675 1 . 0675
Convexity = è ø = 21.49
$1,031.40 ´ (1.0675)
2

– % change in bond price :

– (–0.005)×4.16 + ½×21.49×(–0.005)2 = 2.11%.
(% change approximation using only duration was 2.08%)
 Convertible bonds
• A special type of bond that can be exchanged into some
more junior grade of securities (usually into common
stock)

• Conversion value = # of equivalent common shares

multiplied by the current share price

• Premium to conversion = % over conversion value at

which the convertible trades

• Break even time = # of years needed to recover the

conversion premium with the convertible’s higher income
•Example:
A common stock pays a 35¢ dividend and has a price of $55/share.
The company also has 6% convertible bond selling at 118% of the par
value, convertible into common at $50/share.

What is the conversion ratio, conversion value, and premium to convert?

Solution:
The conversion ratio is $1,000/$50 = 20:1.
The conversion value is 20´$55 = $1,100.
The premium to convert is $1,180 - $1,100 = $80.

• Interest from convertible bond: $60

• Dividend from stocks when converted: $7
• Therefore, holding convertible yields higher income.
 Bond Investment Strategies
• Why invest in bonds?
– Stable income and diversification

• Asset allocation: the process of diversifying an

investment portfolio across various asset
categories, like stocks and bonds and cash to
balance the risk/reward tradeoff.

– Prime benefit: the risk reduction

– Even modest amount of diversification can sharply
dampen portfolio risk
 Maturity-Based Strategies

• Laddering: for an investor who seeks

greater interest income with minimum price
volatility
– Construct a portfolio using bonds with a
series of targeted maturities,
resembling a bond maturity “ladder”

n Barbell strategy: concentrates on both

very short term and very long term bonds
(six month T-bill and 30 year T-bonds)

n Bond swap: the simultaneous sale and

purchase of fixed income securities