Learning Objectives
• Understand why bond prices and interest rates move in the opposite direction
• Describe the structure of TIPS
• Use supply and demand analysis to explain the effect of various events on the interest rate
• Use supply and demand analysis to explain the Fisher effect.
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TIPS (Treasury Inflation Protection Securities)
• Originally issued in 1997.
• Interest and principal payments are adjusted for inflation.
• In times of high inflation the $ amount paid to investors rises.
• Return on TIPS relative to regular Treasurys provides information on expected inflation.
Supply and Demand of Bonds
Supply: borrowers (issuers of bonds)
Demand: lenders (buyers of bonds)
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Shift Factors for the Demand for Bonds
• Wealth
• Expected return
• Expected interest rate
• Inflationary expections
• Relative Risk
• Relative Liquidity
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1. Profitability of Investment Opportunities
Business cycle expansion, investment opportunities , Bs , Bs shifts out to right
2.Expected Inflation
e , Bs , Bs shifts out to right
3.Government Activities
Deficits , Bs , Bs shifts out to right
Shift Factors for Supply of Bonds
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Changes in e: the Fisher Effect
If e 1. Bd shifts in to
left2. Bs , Bs shifts
out to right3. P , i
© 2005 Pearson Education Canada Inc.
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• What will happen to bond prices if stock trading commissions decrease? Why?
• What will happen to bond prices if bond trading commissions increase? Why?
• What will happen to bond prices if the government implements tax increases? Why?
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• If government revenues drop significantly (and remember all else stays the same, including government expenditures), what will likely happen to bond prices? Why?
• If the government guaranteed the payment of bonds, what would happen to their prices? Why?
• What will happen to bond prices if the government implements regulatory reforms that reduce regulatory costs for businesses? Why?
• If government revenues increase significantly, what will likely happen to bond prices? Why?
• What will happen to bond prices if terrorism ended and the world’s nations unilaterally disarmed and adopted free trade policies? Why?
• What will happen to bond prices if world peace brought substantially lower government budget deficits?
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Changes in the money supply
Two effects:
The initial effect of more money to invest lowers the interest rate, but if market participants expect inflation then the Fisher effect will cause the interest rate to increase.
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