Question

When FED announces to increase interest rates? What should happen to stock market portfolio price?

1. Price should drop.

2. Price should Increase.

3. Price should drop by a magnitude closer to the drop seen in a 20-year zero-coupon bond than to that in a 1-year bond.

4. Price increase because expected return increases.

1, 3

1

2

2, 4

Answer 1

When the FED increases the rate, then the rate of discount or the cost of capital goes up.

Thus, the future share price and dividend will be descounted at a higher interest rate, leading to a drop in share price.

Such drops are generally temporary because FED keeps revising rate from time to time and one rate in general doesn't have a horizon of more than 1 years.

Thus, price will drop but to an extent of that in a 1 year bond only.

ONLY STATEMENT 1 is correct.

OPTION B