stocks and bonds

Interest rate changes and market prices, underlying assumptions MATTER
Background:
In finance, we value investments (including stocks and bonds) based on their expected
future cash flows, which we then discount “at the appropriate (required) rate”. Think
about the basic equation for present value: PV = FV/(1 + r) where PV is the present
value, or expected price we would pay for an investment, FV is the future cash flow and
“r” is the required rate of return for the investment. Each expected future cash flow is
discounted for the appropriate number of years. Interest rates are driven heavily by
inflation.
From this, it is easy to see why if the interest rate increases, the PV, or expected price
is expected to decrease. The important thing to note here is “expected future cash
flows”. When we say that “interest rates have risen, what is the effect on prices?” the
underlying assumption is that THE ONLY THING THAT HAS CHANGED IS THE
INTEREST RATE, this is why we always stick to the assumption “all else equal”.
Discussion:
In recent weeks you may well have seen articles in the business press that seem to
conflict with our underlying assumption above. “The market” looks at the bigger picture,
factoring in not only inflation expectations and the effect on interest rates, but on other
market forces, such as consumer attitudes, forecast economic recovery, etc. The
market does not use the assumption “all else equal”!
For this week there are two different articles that will form the basis of the discussion,
start with the article from the Associated Press, “Bond and stock prices fall on higher
interest (inflation) rates”, it provides a basic overview of the price and return (yield)
relationships. Next, read the article from Yahoo Finance “Stocks rise on higher interest
rates”.
1) Discuss the difference in the two articles and then 2) research at least one additional
credible source that deepens the discussion, supporting the concept of the market
having the “bigger picture” in mind. 3) From your supporting article(s), indicate what are
the “other market forces” that are being factored in and how/why each affects stock
(and/or bond) prices.
Double-spaced, Times New Roman, 12 point font size, 500 words minimum, at least 1
external source (but no more than

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