On the Relationship Between Stocks and Bonds

On the relationship between stocks and bonds Simon Kwan Part I (Macroeconomic Analysis)

 What causes the change in i? – Expected inflation – Economic growth

Expected Inflation  Bonds (T-bonds)

 Stock (income)

 Bonds    i 

PV = FP/(1+i)n PBOND

 Stocks    i 

PSTOCK

Economic Slowdown GDP   i  (usually)

 Bonds

 Stocks GDP   Pstock

  Data

Stock prices

Bond prices On the relationship between stocks and bonds Simon Kwan Part II (Microeconomic Analysis)

 Question: What is the relationship between the price of a firm’s stock and bonds? – Corporate Bonds • interest rates • default risk

Good news about future cash flow

 1  g  N FP P  D t Stock 0   PBonds   t  k e  g  t1 (1  i) g

High-Risk Project 50% success => huge increase in earnings 50% failure => bankrupt

 without project Bonds $1,000 Stocks $1,000

 with project Bonds • 50% failure payment =

• 50% success payment =  with project Stocks • 50% failure payment =

• 50% success payment =

 Data – Kwan finds • prices tend to move together – Not true for firms with AAA-rated bonds • •

 Is there a lead-lag relationship? – Theory: Efficient Markets • prices reflect all available information – Problem: •

 Good news to the firm. (Awarded a large no-bid contract.)

 Insiders buy stock Price of stock increases

 News becomes public Public buy stock and bonds Prices of both increase