Risk Equity Prices and Excess Return

We noted above that, at least in the United Kingdom and the United States, the rate of return on equities over the last 100 years had, on average, substantially exceeded the rate of return available on government bonds. This makes perfect sense as long as the risk on equities substantially exceeds the risk of those other investments. But what do we mean by risk here, and how might we measure it The answer to these questions matters a lot, because movements in the risk premium can dramatically...

Future dividends should influence todays stock price

However, note that while the current stock price reflects information about all future dividends, all dividends are not equally important. Because of discounting, current dividends influence the current stock price more than dividends in the far future. The discounting works as follows. The current stock price depends on the discounted expected price and dividends next period, P(0) P(1) + D(1) (1 + r). We also know that next period's price equals the discounted value of expected prices and...

Exchange Rate Regimes

There are a range of exchange rate regimes available to countries, varying in the flexibility they allow for the exchange rate. With a floating exchange rate, the value of a country's currency can vary freely depending on the forces analyzed in Chapters 19 and 20. By contrast, with a fixed exchange rate, the government will either change interest rates or sell buy foreign currency to maintain a fixed value for the currency, as described earlier in this chapter. Throughout the nineteenth century...

Comparative advantage means that all countries can benefit from free trade even if they are characterized by low levels

The theory of comparative advantage says that all countries can benefit from trade. However, there are some things comparative advantage does not imply (a) Comparative advantage says all countries gain from trade, but not that all countries become wealthy. As we saw in Chapters 3 though 6, the standard of living in a country depends on its absolute productivity. In our example, Eurasia is more productive than Oceania and so has a better standard of living (compare the level of onions per capita...

Are Stock Prices Forecastable

Belief in efficient (or rational) stock market pricing has taken big blows over the last 20 years. Robert Shiller led the intellectual assault on belief in stock market efficiency in a series of papers written more than 20 years ago.10 In 1981 Shiller argued that stock prices in the United States over the 100-year period starting in 1870 were far too volatile to be consistent with a rational evaluation of the fundamental value of the corporate sector.11 Shiller wanted to compare the volatility...

Glossary

Active labor market spending Expenditure by the government aimed at increasing the probability of the unemployed being hired. Adverse selection A problem of asymmetric information where one side of a transaction will find itself coming into contact with agents that make the transaction unprofitable and is unable to exclude them, e.g., when a bank fears that if it raises interest rates it will attract high risk borrowers who face a high probability of bankruptcy. Aggregate demand curve The...