Explain why an economic factor can move market values only by acting on at least one of three channels: default-free rates at each maturity, how large and how soon expected cash flows are, and risk premiums
The idea
A price is the present value of expected cash flows, discounted at the default-free rate for each maturity plus a risk premium. Economic news can therefore move prices through only three channels: it can shift the default-free yield curve, change the size or timing of expected cash flows, or change the premium investors demand for bearing risk. A surprise rise in unemployment may cut expected profits, lower policy rates and raise risk aversion at once. The trap is to label a headline good or bad for prices on its own: strong growth data can lower equity prices if it lifts expected interest rates by more than it lifts expected cash flows.
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