Expectations and Market Valuation

The return on any asset is determined by the expectation of future discount rate fluctuations. If interest rates are expected to fall, short-term investments will be less attractive while long-term investments will get more attractive. Longer-term bonds will continue to give investors higher rates of return, and hence, higher values.

Additionally, anticipated information influences the amounts of expected cash flows. Non-anticipated information, on the other hand, constitutes real news and requires an adjustment of the expectations. We can deduce that releases of economic information generate counterintuitive market reactions from investors. The expectations for these releases affect investors’ judgment. For instance, asset prices may fall despite “good” news, if the expectation was for better news.

Question

If the prevailing discount rate is expected to fall, which of the following statements is most accurate?

1. Demand for short term investments will decrease.
2. Price of short-term investments will increase.
3. Price of long-term investments will fall.

Solution

The correct answer is A.

The attraction of short-term and long-term investments vary in line with expectations of future movements in discount rates. If the prevailing discount rates are expected to fall, short-term investments will be less attractive, since people expect to be able to borrow cheaply soon. The demand for short-term investments will then decrease, making their prices to fall, leading to higher returns.

Conversely, the demand for long-term investments will rise, and so will their prices, leading to lower returns.

B is incorrect. The price of short-term investments will decrease due to the decreased demand.

C is incorrect. The price of long-term investments will increase due to the increased demand.

Reading 43: Economics and Investment Markets

LOS 43 (b) Explain the role of expectations and changes in expectations in market valuation.