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LEARNING OBJECTIVES
After studying this chapter, you should be able to:
4.1
Discuss the most important factors in building an investment portfolio.
4.2
4.3
Use a demand and supply model to determine market interest rates for
bonds.
Use the bond market model to explain changes in interest rates.
4.4
Use the loanable funds model to analyze the international capital market.
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Are There Any Safe Investments?
•Recently, interest rates on U.S. Treasury notes and corporate bonds
have been falling from their historical averages.
•If interest rates on those securities rose back to their historical
averages, bond holders would suffer capital losses.
•Many financial advisers have warned investors of this interest rate
risk in holding bonds.
•In this chapter, we study how investors take into account
expectations of inflation and other factors when making investment
decisions.
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Key Issue and Question
Issue: Federal Reserve policies to combat the recession of 2007–
2009 led some economists to predict that inflation would rise and
make long-term bonds a poor investment.
Question: How do investors take into account expected inflation and
other factors when making investment decisions?
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4.1 Learning Objective
Discuss the most important factors in building an investment portfolio.
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How to Build an Investment Portfolio
The Determinants of Portfolio Choice
Determinants of portfolio choice (asset demand) are:
1. The saver’s wealth
2. The expected rates of return from different investments
3. The degrees of risk in different investments
4. The liquidity of different investments
5. The costs of acquiring information about different investments
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Wealth
An increase in wealth generally increases the quantity demanded for most
financial assets.
Expected Rate of Return
Expected return is the return expected on an asset during a future period.
The expected return on an investment is:
Expected return = [(Probability of event 1 occurring) X (Value of event 1)]
+ [(Probability of event 2 occurring) X (Value of event 2)].
Example: Equal probability of a rate of return of 15% and 5%.
Expected return = (0.50)(15%) + (0.50)(5%) = 10%.
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Risk
Risk is the degree of uncertainty in the return on an asset.
• Most investors are risk averse – choose the asset with the lower risk when
two assets have the same expected returns – resulting in trade-offs between
risk and return.
• Risk-loving investors prefer to hold risky assets with the possibility of
maximizing returns.
• Risk-neutral investors make decisions on the basis of expected returns,
ignoring risk.
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Making the Connection
Fear the Black Swan!
• Investors in stocks of small companies from 1926 to 2011 experienced the
highest average returns but also accepted the most risk (measured by the
standard deviation of returns).
• U.S. Treasury bills had the lowest average returns but also the least risk.
• Some economists see the financial crisis as a black swan – a rare event that
has a large impact on the economy – which might affect the conventional
measure of risk.
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Liquidity
• The greater an asset’s liquidity, the more desirable the asset is to investors.
The Cost of Acquiring Information
• All else being equal, investors will accept a lower return on an asset that has
lower costs of acquiring information.
Desirable characteristics of a financial asset cause the quantity of the asset
demanded by investors to increase, and vice versa.
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How to Build an Investment Portfolio
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Diversification
Diversification is dividing wealth among many different assets to reduce risk.
Market (systematic) risk is risk that is common to all assets of a certain type,
e.g., changes in stock returns as a result of the business cycle.
Idiosyncratic (unsystematic) risk is risk that pertains to a particular asset (or
a firm) rather than to the market as a whole.
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Making the Connection
In Your Interest
How Much Risk Should You Tolerate in Your Portfolio?
• Your time horizon is an important factor in deciding on the degree of risk.
• Saving plans are also affected by the effects of inflation and taxes.
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4.2 Learning Objective
Use a demand and supply model to determine market interest rates for bonds.
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Market Interest Rates and the Demand and Supply for
Bonds
• A bond’s price (P) and its yield to maturity (i) are linked by the equation
showing its coupon payments (C), face value (FV) and maturity in n years:
• Because C and FV do not change, once we know P in the bond market, we
have determined the equilibrium i.
• The bond market approach (bonds as the good) is useful when considering
how the factors affecting the demand and supply for bonds affect the interest
rate.
• The market for loanable funds approach (funds as the good) is useful when
considering how changes in the demand and supply of funds affect the
interest rate.
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A Demand and Supply Graph of the Bond Market
Figure 4.1
The Market for Bonds
The equilibrium price of bonds is
determined in the bond market.
By determining the price of
bonds, the bond market also
determines the interest rate on
bonds.
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Figure 4.2
Equilibrium in Markets for Bonds
At $960, the quantity of bonds
demanded by investors equals the
quantity of bonds supplied by
borrowers.
At any price higher or lower than
$960, the quantity of bonds demanded
is not equal to the quantity of bonds
supplied.
The interest rate on the bond is:
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Explaining Changes in Equilibrium Interest Rates
In drawing the demand and supply curves for bonds, factors other than the
prices of bonds are held constant.
If the price of bonds changes, we move along the demand (supply) curve, so
we have a change in quantity demanded (supplied).
If any other relevant variable changes, then the demand (supply) curve shifts,
and we have a change in demand (supply).
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Factors That Shift the Demand Curve for Bonds
Five factors cause the demand curve for bonds to shift:
1. Wealth
2. Expected return on bonds
3. Risk
4. Liquidity
5. Information costs
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Wealth
Figure 4.3 (1 of 2)
Shifts in the Demand
Curve for Bonds
An increase in wealth will shift
the demand curve for bonds to
the right. As a result, both the
equilibrium price of bonds and
the equilibrium quantity of
bonds increase.
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Wealth
Figure 4.3 (2 of 2)
Shifts in the Demand
Curve for Bonds (continued)
A decrease in wealth will shift
the demand curve for bonds to
the left. As a result, both the
equilibrium price and the
equilibrium quantity of bonds
decrease.
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Expected Return on Bonds
If the expected return on bonds rises relative to expected returns on other
assets, investors will increase their demand for bonds.
Risk
A decrease in the riskiness of bonds relative to the riskiness of other
assets increases the willingness of investors to buy bonds.
Liquidity
If the liquidity of bonds increases, investors demand more bonds at any
given price.
Information Costs
As a result of the lower information costs, investors are more willing to buy
bonds.
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Table 4.2 (1 of 3)
Factors That Shift the Demand Curve for Bonds
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Table 4.2 (2 of 3)
Factors That Shift the Demand Curve for Bonds
Market Interest Rates and the Demand and Supply for Bonds
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Table 4.2 (3 of 3)
Factors That Shift the Demand Curve for Bonds
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Factors That Shift the Supply Curve for Bonds
Important factors for explaining shifts in the supply curve for bonds:
1. Expected pretax profitability of physical capital investments
2. Business taxes
3. Expected inflation
4. Government borrowing
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Expected Pretax Profitability of Physical Capital Investments
Figure 4.4 (1 of 2)
Shifts in the Supply
Curve for Bonds
An increase in firms’
expectations of the profitability
of investments in physical
capital will shift the supply
curve for bonds to the right.
As a result, the equilibrium
price of bonds falls and the
equilibrium quantity of bonds
rises.
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Expected Pretax Profitability of Physical Capital Investments
Figure 4.4 (2 of 2)
Shifts in the Supply
Curve for Bonds (continued)
If firms become pessimistic
about the profits they could
earn from investing in physical
capital, the supply curve for
bonds will shift to the left.
As a result, the equilibrium
price increases and the
equilibrium quantity of bonds
decreases.
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Business Taxes
When business taxes are raised, the profits on new investments in physical
capital decline, and firms issue fewer bonds.
Expected Inflation
For any given nominal interest rate, an increase in the expected rate of inflation
reduces the expected real interest rate.
A lower expected real interest rate is attractive for a firm as it will pay less in
real terms to borrow funds.
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Government Borrowing
Figure 4.5
The Federal Budget, 1960-2012
The recession of 2007–2009 led to record federal government deficits that required
borrowing heavily by selling bonds.
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Making the Connection
Why Are Bond Interest Rates So Low?
If nothing else changes, a larger government deficit and thus borrowing shifts
the bond supply curve to the right, resulting in a higher interest rate.
In 2012, bond interest rates remained low despite record deficits.
When the government runs a deficit, households may begin to increasing
saving in anticipation for future tax payments to finance the deficit.
Due to increased household saving, the demand curve for bonds shifts to the
right when the supply curve for bonds also shifts to the right.
As a result, the interest rate would not rise.
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Table 4.3 (1 of 2)
Factors That Shift the Supply Curve for Bonds
Market Interest Rates and the Demand and Supply for Bonds
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Table 4.3 (2 of 2)
Factors That Shift the Supply Curve for Bonds
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4.3 Learning Objective
Use the bond market model to explain changes in interest rates.
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The Bond Market Model and Changes in Interest Rates
Examples of using the bond market model to explain changes in interest rates:
(1) The movement of interest rates over the business cycle.
(2) The Fisher effect, which is the movement of interest rates in response to
changes in the inflation rate.
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Why Do Interest Rates Fall During Recessions?
Figure 4.6
Interest Rate Changes in an
Economic Downturn
1. An economic downturn
reduces household wealth
and thus decreases the
demand for bonds.
2. The fall in expected
profitability reduces
lenders’ supply of bonds.
3. In the new equilibrium (E2),
the bond price rises.
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How Do Changes in Expected Inflation Affect Interest Rates?
The Fisher Effect
The Fisher effect (asserted by Irving Fisher) indicates that the nominal interest
rate changes point-for-point with changes in the expected inflation rate.
The Fisher effect implies that:
1. Higher inflation rates result in higher nominal interest rates, and vice versa.
2. Changes in expected inflation can lead to changes in nominal interest rates
before a change in actual inflation occurrs.
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Figure 4.7
Expected Inflation and
Interest Rates
1. An increase in expected
inflation reduces investors’
expected real return, thus the
demand curve for bonds
shifts to the left.
2. The increase in expected
inflation increases firms’
willingness to issue bonds,
thus the supply curve for
bonds shifts to the right.
3. In the new equilibrium (E2),
the bond price falls.
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Solved Problem 4.3
In Your Interest
Should You Worry About Falling Bond Prices When the Inflation Rate Is Low?
The inflation rate in late 2012 was about 2%. In the Wall Street Journal, a
columnist wrote: “Someone buying long-term bonds yielding 1.5% or 2%, and
then seeing consumer price inflation of 4%, will be on the losing end of the
bet.”
a. Explain what will happen to the price of bonds if the expected inflation rate
increases to 4% from 2%. Include a demand and supply graph of the bond
market.
b. Suppose that you expect a greater increase in inflation than do other
investors, but that you don’t expect the increase to occur until 2015. Should
you wait until 2015 to sell your bonds? Briefly explain.
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Solved Problem 4.3
In Your Interest (continued)
Should You Worry About Falling Bond Prices When the Inflation Rate Is Low?
c. The columnist also argued that long-term bonds would be a good investment
only if “we get serious price deflation.” Explain the effect on bond prices if
investors decide that price deflation is likely to occur. How would an
unexpected deflation affect the rate of return on your investment in bonds?
d. If expected inflation is increasing, would you have made a worse investment
if you had invested in long-term bonds than if you had invested in short-term
bonds?
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Solved Problem 4.3
In Your Interest
Should You Worry About Falling Bond Prices When the Inflation Rate Is Low?
Solving the Problem
Step 1 Review the chapter material.
Step 2 Answer part (a) by explaining
why an increase in expected
inflation may make bonds a
bad investment and illustrate
your response with a graph.
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Solved Problem 4.3
In Your Interest
Should You Worry About Falling Bond Prices When the Inflation Rate Is Low?
Solving the Problem (continued)
Step 3 Answer part (b) by discussing the difference in the effects of actual and
expected inflation on changes in bond prices.
Changes in bond prices result from changes in the expected rate of inflation. If
buyers and sellers change their expectations, the nominal interest rate will
adjust. Waiting until the nominal interest rate had risen would be too late to
avoid the capital losses from owning bonds.
Step 4 Answer part (c) by explaining the effect on the bond market of unexpected
deflation.
An unexpected deflation will shift the demand curve for bonds to the right and
the supply curve to the left. The price of bonds will increase as a result, so a
bond investor will experience a higher rate of return or capital gain.
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Solved Problem 4.3
In Your Interest (continued)
Why Worry About Falling Bond Prices When the Inflation Rate Is Low?
Solving the Problem (continued)
Step 5 Answer part (d) by explaining why long-term bonds are a particularly bad
investment if expected inflation increases.
An increase in expected inflation will increase the nominal interest rate on all
bonds, but the increases will be more on bonds with a longer maturity. So, the
capital losses on long-term bonds will be greater than on short-term bonds.
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4.4 Learning Objective
Use the loanable funds model to analyze the international capital market.
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The Loanable Funds Model and the International Capital
Market
A borrower is the buyer of loanable funds and a lender is the seller.
When looking at the flow of funds between the U.S. and foreign financial
markets, the loanable funds approach is more useful than the demand and
supply of bonds approach.
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The Demand and Supply of Loanable Funds
Figure 4.8
The Demand for Bonds and the Supply of Loanable Funds
In panel (a), the bond demand curve (Bd) shows a negative relationship between the
quantity of bonds demanded by lenders and the price of bonds.
In panel (b), the supply curve for loanable funds (Ls) shows a positive relationship
between the quantity of loanable funds supplied by lenders and the interest rate.
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The Demand and Supply of Loanable Funds
Figure 4.9
The Supply of Bonds and the Demand for Loanable Funds
In panel (a), the bond supply curve (Bs) shows a positive relationship between the
quantity of bonds supplied by borrowers and the price of bonds.
In panel (b), the demand curve for loanable funds (Ld) shows a negative relationship
between the quantity of loanable funds demanded by borrowers and the interest rate.
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Equilibrium in the Bond Market from the Loanable Funds Perspective
Figure 4.10
Equilibrium in the Market for
Loanable Funds
At the equilibrium interest rate,
the quantity of loanable funds
supplied by lenders equals the
quantity of loanable funds
demanded by borrowers.
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The International Capital Market and the Interest Rate
The foreign sector influences the domestic interest rate and the quantity of
funds available in the domestic economy.
The loanable funds approach provides a good framework for analyzing the
interaction between U.S. and foreign bond markets.
In a closed economy, households, firms, and governments do not borrow or
lend internationally.
In an open economy, households, firms, and governments borrow and lend
internationally.
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Small Open Economy
In a small open economy, the quantity of loanable funds supplied or
demanded is too small to affect the world real interest rate.
Key Features:
•The real interest rate in a small open economy is the same as the interest rate
in the international capital market.
•If the quantity of loanable funds supplied domestically exceeds the quantity of
funds demanded domestically, the country invests some of its loanable funds
abroad.
•If the quantity of loanable funds demanded domestically exceeds the quantity
of funds supplied domestically, the country finances some of its domestic
borrowing needs with funds from abroad.
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Small Open Economy
Figure 4.11
Determining the Real Interest
Rate in a Small Open
Economy
The domestic real interest rate
in a small open economy is the
world real interest rate (rw),
which is 3% in this case.
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Large Open Economy
In a large open economy, changes in the demand and supply for loanable
funds are large enough to affect the world real interest rate.
In this case, we cannot assume that the domestic real interest rate is equal to
the world real interest rate.
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Figure 4.12
Determining the Real Interest Rate in a Large Open Economy
The world real interest rate adjusts to equalize desired international borrowing and
desired international lending.
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Making the Connection
Did a Global “Saving Glut” Cause the U.S. Housing Boom?
In response to the argument that the Fed’s low-interest-rate policy in the 2000s
fueled the housing boom, Ben Bernanke argued that “a significant increase in
the global supply of saving—a global saving glut . . . helps to explain . . . the
relatively low level of long-term interest rates in the world today.”
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Answering the Key Question
At the beginning of this chapter, we asked the question:
“How do investors take into account expected inflation and other factors
when making investment decisions?”
Investors change their demand for bonds as a result of changes in a
number of factors.
When expected inflation increases, the real interest rate decreases and
thus investors reduce their demand for bonds for each nominal interest
rate.
Increases in expected inflation also lead to higher nominal interest rates
and capital losses for investors who hold bonds.
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