<p>On the relationship between stocks and bonds Simon Kwan Part I (Macroeconomic Analysis)</p><p> What causes the change in i? – Expected inflation – Economic growth</p><p>Expected Inflation  Bonds (T-bonds)</p><p> Stock (income)</p><p> Bonds    i  </p><p>PV = FP/(1+i)n PBOND </p><p> Stocks    i  </p><p>PSTOCK </p><p>Economic Slowdown GDP   i  (usually)</p><p> Bonds</p><p> Stocks GDP   Pstock </p><p>  Data</p><p>Stock prices</p><p>Bond prices On the relationship between stocks and bonds Simon Kwan Part II (Microeconomic Analysis)</p><p> Question: What is the relationship between the price of a firm’s stock and bonds? – Corporate Bonds • interest rates • default risk</p><p>Good news about future cash flow</p><p> 1  g  N FP P  D t Stock 0   PBonds   t  k e  g  t1 (1  i) g </p><p>FPt </p><p>High-Risk Project 50% success => huge increase in earnings 50% failure => bankrupt</p><p> without project Bonds $1,000 Stocks $1,000</p><p> with project Bonds • 50% failure payment = </p><p>• 50% success payment =  with project Stocks • 50% failure payment = </p><p>• 50% success payment = </p><p> Data – Kwan finds • prices tend to move together – Not true for firms with AAA-rated bonds • • </p><p> Is there a lead-lag relationship? – Theory: Efficient Markets • prices reflect all available information – Problem: •</p><p> Good news to the firm. (Awarded a large no-bid contract.)</p><p> Insiders buy stock Price of stock increases</p><p> News becomes public Public buy stock and bonds Prices of both increase</p>