DETERMINING MARKET

DETERMINING MARKET INTEREST RATES

Chapter 4 Part 2Finance 327

Two Views of the Bond Market(1) Bond is the good.

(2) Use of funds is the good.

Bond Is the Good Perspective:

Buyer: Lender who buys bond

Seller: Borrower issuing bond

Price: Bond price

Use of Funds Is the Good Perspective

Buyer: Borrower raising funds

Seller: Lender supplying funds

Price: Interest rate (i) = YTM on the bond

For zero coupon bond, i = (Face - Discount Price) / Discount Price (remember YTM for a zero-coupon bond is just (total interest / what you initially paid for the bond)

Also recall that the bond price moves inversely to interest rates

Demand for Bonds:

Supply of Bonds:

Market Equilibrium (holding everything else constant):

Explaining Changes in Equilibrium Interest Rates (or, letting the other things held constant change):

Changes in bond demand or supply will change the bond price and interest rate.

Theory of portfolio allocation can explain bond demand curve shifts.

Changes in willingness and ability to borrow shifts the supply curve.

Factors that INCREASE Bond DEMAND

(1) Higher wealth (assumes that the wealth elasticity of bonds is greater than 1.0)

(2) Higher expected returns on bonds (or lower expected return on other assets)

(3) Lower relative riskiness of bonds

(4) Higher relative liquidity of bonds

(5) Lower relative information costs of bonds

Shifts in Bond Demand: Changes in one or more of these factors

Factors that INCREASE Bond SUPPLY

(1) Higher profitability from investments that the firms make

(2) Lower business taxes

(3) Expected inflation

(4) Higher government borrowing

Shifts in Bond Supply: Changes in one or more of these factors

Application 1: Why Do Interest Rates Fall During Recessions?

Application 2: Expected Inflation and Interest Rates

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Government borrowing

Figure 4.5The Federal BudgetWith the exception of a few years in the late 1990s, the federal government has typically run a budget deficit. The recession of 20072009 led to record deficits that required the federal government to borrow heavily by selling bonds.

Market Interest Rates and the Demand and Supply for Bonds

2012 Pearson Education, Inc. Publishing as Prentice Hall

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Solved Problem4.3Why Worry About Falling Bond Prices When the Inflation Rate Is Low?The Bond Market Model and Changes in Interest RatesThe inflation rate in late 2009 was quite low, but financial advisor Bill Tedford forecast that inflation would increase to 5% by 2011. He argued that this increase in inflation made bonds a bad investment. Tedford was hardly alone in offering this advice. For instance, in its March 2010 issue, Consumer Reports magazine advised its readers to steer clear of long-term Treasury bonds.

a. Explain why an increase in expected inflation will make bonds a bad investment. Include a demand and supply graph of the bond market.

b. If inflation was not expected to increase until 2011, should investors have waited until then to sell their bonds? Briefly explain.

c. In its advice, Consumer Reports singles out long-term bonds as an investment for its readers to avoid. Why would long-term bonds be a worse investment than short-term bonds if expected inflation was increasing?

2012 Pearson Education, Inc. Publishing as Prentice Hall

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