Financial Asset Prices

The prices of financial assets such as stocks and bonds are affected by interest rates, perceived riskiness, and expected future returns. Changes in these factors affect the current price of financial assets in a predictable way.

Exploration: How do changes in interest rate, expected financial risk, and expected future returns affect financial asset prices?

The applet above illustrates the relationship among interest rates, the expected future value of an asset, and the price of that asset today. Use the slider to change the market interest rate or click on the number in the "Value in One Year" box to change the expected future value of the asset. The price of the asset today will reflect these changes. Click the Reset button to restore the original values.

1. You expect a share of a company to be worth $58 in one year and pay a $1 dividend at that time. What should you be willing to pay for the stock today if the prevailing interest rate in the market (equal to your required rate of return) is 5%? How would your answer change if the prevailing interest rate was instead 2%? What do you conclude about the relationship between stock prices and interest rates?
   
   
2. You expect a share of a company to be worth $99 in one year and pay no dividend. What should you be willing to pay for the stock today if the prevailing interest rate in the market (equal to your required rate of return) is 4%? How would your answer change if economic news was released indicating a likely slowing of the economy over the next year? How does "bad" economic news about the future affect stock prices today?
   
   
3. During the late 1990s, stocks of Internet-related companies often rose dramatically, helping to fuel a dramatic broad increase in the stock market. Use the relationship above to help explain why this might occur, despite the fact that these companies often had negative profits at the time that their stock prices were rising. Explain how this dramatic rise in stock prices could also reverse quickly, leading to a significant drop in stock prices.
   
   
4. If you expect the Federal Reserve to increase interest rates in the near future, would it be a good time to buy bonds? Why or why not?
   
   
5. Assume that you are currently holding a three-year government bond that was issued at a face value of $1000 and a coupon rate of 8%, payable at the end of each year. One year prior to the bond's maturation, the Federal Reserve cuts interest rates from 10% to 4%. What would you expect to happen to the current price of the bond?
   
   
6. Assume that you are currently holding a three-year government bond that was issued at a face value of $10,000 and a coupon rate of 4%, payable at the end of each year. One year prior to the bond's maturation, bond prices begin to fall dramatically. What has happened to interest rates? How do you know?
   
   

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