Download Chapter 4. Understanding Interest Rates

THE BOND MARKET
Frederick University
2014
The Bond Market



Bond supply
Bond demand
Bond market equilibrium
Bond supply

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bond issuers/ borrowers
look at Qs as a function of price, yield
Bond supply
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lower bond prices
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higher bond yields
more expensive to borrow
lower Qs of bonds
so bond supply slopes up with price
Bond
price
S
Q of bonds
Bond Demand

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bond buyers/ lenders/ savers
look at Qd as a function of bond
price/yield
Bond
yield
Qd of
bonds
price
of bond
Qd of
bonds
bond demand slopes down with respect
to price
Bond
price
D
Quantity of bonds

Changes in bond price/yield
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Move along the bond demand curve
What shifts bond demand?
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Wealth
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Higher wealth increases asset demand
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Bond demand increases
Bond demand shifts right
P
D
D
Qd
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a change in expected inflation

rising inflation decreases real return
inflation
expected
to
demand for
bonds
(shift left)

a change in exp. interest rates

rising interest rates decrease value of existing
bonds
int. rates
expected
to
demand for
bonds
(shift left)

a change in the risk of bonds relative to
other assets
relative
risk of
bonds
demand for
bonds
(shift left)

a change in liquidity of bonds relative to
other assets
relative
liquidity
of bonds
demand for
bonds
(shift rt.)
Bond supply

Changes in bond price/yield

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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
S
S’
Qs
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a change in business conditions

affects incentives to expand production
exp.
profits

supply of
bonds
(shift rt.)
exp. economic expansion shifts bond supply
rt.

a change in expected inflation

rising inflation decreases real cost of
borrowing
exp.
inflation
supply of
bonds
(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
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expected inflation 3%
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exp. inflation rises to 4%
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bond demand
-- real return declines
-- Bd decreases
bond supply
-- real cost of borrowing declines
-- Bs increases

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bond price falls
interest rate rises
Fisher effect
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expected inflation rises,
nominal interest rates rise
Example 2: economic
slowdown
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bond demand
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decline in income, wealth
Bd decreases
P falls, i rises
bond supply
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decline in exp. profits
Bs decreases
P rises, i falls
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shift Bs > shift in Bd
interest rate falls
Why shift Bs > shift Bd?
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changes in wealth are small
response to change in exp. profits is
large
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large cyclical swings in investment
Why are bonds risky?
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3 sources of risk
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Default
Inflation
Interest rate
Default risk
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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
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Inflation erodes the real value of these
payments
Future inflation is unknown
Larger for longer term bonds
Interest rate risk
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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