Table Of ContentEconomics for Financial Markets
Butterworth-Heinemann Finance
Aims and Objectives
(cid:2) books based on the work of financial market practitioners, and
academics
(cid:2) presenting cutting edge research to the professional/practitioner market
(cid:2) combining intellectual rigour and practical application
(cid:2) covering the interaction between mathematical theory and financial
practice
(cid:2) to improve portfolio performance, risk management and trading book
performance
(cid:2) covering quantitative techniques
Market
Brokers/Traders; Actuaries; Consultants; Asset Managers; Fund Managers;
Regulators; Central Bankers; Treasury Officials; Technical Analysts; and
Academics for Masters in Finance and MBA market.
Series titles
Return Distributions in Finance
Derivative Instruments: theory, valuation, analysis
Managing Downside Risk in Financial Markets: theory, practice, and
implementation
Economics for Financial Markets
Global Tactical Asset Allocation: theory and practice
Performance Measurement in Finance: firms, funds and managers
Real R&D Options
Series Editor
Dr Stephen Satchell
Dr Satchell is Reader in Financial Econometrics at Trinity College, Cam-
bridge, Visiting Professor at Birkbeck College, City University Business School
and University of Technology, Sydney. He also works in a consultative
capacity to many firms, and edits the journal Derivatives: use, trading and
regulations.
Economics for Financial
Markets
Brian Kettell
OXFORD AUCKLAND BOSTON JOHANNESBURG MELBOURNE NEW DELHI
This book is dedicated to my wife Nadia without whose support it
would not have been written and to my sister Pat without whom it
would not have been typed.
Butterworth-Heinemann
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225 Wildwood Avenue, Woburn, MA 01801-2041
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First published 2002
© Brian Kettell 2002
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British Library Cataloguing in Publication Data
Kettell, Brian
Economics for financial markets. – (Quantitative finance
series)
1. Money market
I. Title
332.4
Library of Congress Cataloguing in Publication Data
A catalogue record for this book is available from the Library of Congress
ISBN 0 7506 5384 1
For information on all Butterworth-Heinemann publications visit
our website at www.bh.com and for finance titles in particular go
to www.bh.com/finance
Composition by Genesis Typesetting, Laser Quay, Rochester, Kent
Printed and bound in Great Britain
Contents
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
vi Contents
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
Contents vii
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
viii Contents
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
Contents ix
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
