THE BOND MARKET Frederick University 2014. The Bond Market Bond supply Bond demand Bond market equilibrium.
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THE BOND MARKET
Frederick University2014
The Bond Market
Bond supply Bond demand Bond market equilibrium
Bond supply
bond issuers/ borrowers look at Qs as a function of price,
yield
Bond supply
lower bond prices higher bond yields more expensive to borrow lower Qs of bonds
so bond supply slopes up with price
Bond price
Q of bonds
S
Bond Demand
bond buyers/ lenders/ savers look at Qd as a function of bond
price/yield
Bond yield
Qd ofbonds
priceof bond
Qd of bonds
bond demand slopes down with respect to price
Bond price
Quantity of bonds
D
Changes in bond price/yield Move along the bond demand curve
What shifts bond demand?
Wealth Higher wealth increases asset
demand Bond demand increases Bond demand shifts right
P
Qd
DD
a change in expected inflation rising inflation decreases real return
inflationexpected to
demand forbonds(shift left)
a change in exp. interest rates rising interest rates decrease value of
existing bonds
int. ratesexpected to
demand forbonds(shift left)
a change in the risk of bonds relative to other assets
relativerisk of bonds
demand forbonds(shift left)
a change in liquidity of bonds relative to other assets
relative liquidityof bonds
demand forbonds(shift rt.)
Bond supply
Changes in bond price/yield Move along the bond supply curve
What shifts bond supply?
Shifts in bond supply
Change in government borrowing Increase in government borrowing
Increase in bond supply Bond supply shifts right
P
Qs
S
S’
a change in business conditions affects incentives to expand production
exp.profits
supply ofbonds(shift rt.)
exp. economic expansion shifts bond supply rt. exp. economic expansion shifts bond supply rt.
a change in expected inflation rising inflation decreases real cost of borrowing
exp.inflation
supply ofbonds(shift rt.)
Bond market equilibrium
changes when bond demand shifts,and/or bond supply shifts
shifts cause bond prices AND interest rates to change
Example 1: the Fisher effect expected inflation 3%
exp. inflation rises to 4% bond demand
-- real return declines-- Bd decreases
bond supply-- real cost of borrowing declines-- Bs increases
bond price falls interest rate rises
Fisher effect expected inflation rises,
nominal interest rates rise
Example 2: economic slowdown
bond demand decline in income, wealth Bd decreases P falls, i rises
bond supply decline in exp. profits Bs decreases P rises, i falls
shift Bs > shift in Bd interest rate falls
shift Bs > shift in Bd interest rate falls
Why shift Bs > shift Bd?
changes in wealth are small response to change in exp. profits
is large large cyclical swings in investment
Why are bonds risky?
3 sources of risk Default Inflation Interest rate
Default risk
Risk that the issuer fails to make promised payments on time
Zero for government debt Other issuers: corporate, municipal,
foreign have some default risk Greater default risk means a
greater yield
Inflation risk
Most bonds promise fixed interest payments Inflation erodes the real value of
these payments Future inflation is unknown Larger for longer term bonds
Interest rate risk
Changing interest rates change the value (price) of a bond in the opposite direction.
All bonds have interest rate risk But it is larger for the long term
bonds
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