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Understanding Bonds and Interest Rates

This document discusses bonds, bond prices, and interest rates. It covers four types of bonds, how bond prices are determined using concepts like yield to maturity and current yield. It also explains bond supply and demand in financial markets and how equilibrium prices and interest rates are established. Key factors that influence bond prices like expected inflation, economic conditions, and risk are also summarized.

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70 views57 pages

Understanding Bonds and Interest Rates

This document discusses bonds, bond prices, and interest rates. It covers four types of bonds, how bond prices are determined using concepts like yield to maturity and current yield. It also explains bond supply and demand in financial markets and how equilibrium prices and interest rates are established. Key factors that influence bond prices like expected inflation, economic conditions, and risk are also summarized.

Uploaded by

GulEFarisFaris
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd

Chapter 6.

Bonds, bond prices


and interest rates
• Bond prices and yields
• Bond market equilibrium
• Bond risks
Bonds: 4 types
• zero coupon bonds
 e.g. Tbills
• fixed payment loans
 e.g. mortgages, car loans
• coupon bonds
 e.g. Tnotes, Tbonds
• consols
Zero coupon bonds

• discount bonds
 purchased price less than face
value
-- F > P
 face value at maturity
 no interest payments
example

• 91 day Tbill,
• P = $9850, F = $10,000
• YTM solves

$10,000
$9850  91
(1  i ) 365
$10,000
$9850  91
(1  i ) 365

10000
1  i 
91
365 
9850
365
 10000  91
1 i   
 9850 

365
 10000  91
i   1  6.25%
 9850 
yield on a discount basis (127)

• how Tbill yields are actually quoted


• approximates the YTM

F-P 360
idb = x
F d
example

• 91 day Tbill,
• P = $9850, F = $10,000
• discount yield =

 $150   360 
    5.93%
 $10,000   91 
• idb < YTM
• why?
 F in denominator
 360 day year
• fixed-payment loan
 loan is repaid with equal (monthly)
payments
 each payment is combination of
principal and interest
example 2: fixed pmt. loan

• $20,000 car loan, 5 years


• monthly pmt. = $500
• so $15,000 is price today
• cash flow is 60 pmts. of $500
• what is i?
• i is annual rate
 (effective annual interest rate)
• but payments are monthly, &
compound monthly
• (1+im)12 = i
• im= i1/12-1
• im is the periodic rate
• note: APR = im x 12
500 500 500
20000    ... 
1  im  1  im  2
1  im  60

im=1.44%

i=(1+. 0144)12 – 1 =18.71%

APR  .0144 12  17.28%


• how to solve for i?
 trial-and-error
 table
 financial calculator
 spreadsheet
Coupon bond

• (chapter 4)
Bond Yields

• Yield to maturity (YTM)


 chapter 4
• Current yield
• Holding period return
Yield to Maturity (YTM)

• a measure of interest rate


• interest rate where
P = PV of cash flows
Current yield

• approximation of YTM for coupon


bonds

annual coupon payment


ic =
bond price
• better approximation when
 maturity is longer
 P is close to F
example

• 2 year Tnotes, F = $10,000


• P = $9750, coupon rate = 6%
• current yield

ic = 600
= 6.15%
9750
• current yield = 6.15%
• true YTM = 7.37%
• lousy approximation
 only 2 years to maturity
 selling 2.5% below F
Holding period return

• sell bond before maturity


• return depends on
 holding period
 interest payments
 resale price
example

• 2 year Tnotes, F = $10,000


• P = $9750, coupon rate = 6%
• sell right after 1 year for $9900
 $300 at 6 mos.
 $300 at 1 yr.
 $9900 at 1 yr.
300 9900  300
9750  
1 i
2 
1  i 
2
2

i/2 = 3.83%
i = 7.66%
• why i/2?
• interest compounds annually not
semiannually
The Bond Market

• Bond supply
• Bond demand
• Bond market equilibrium
Bond supply

• bond issuers/ borrowers


• look at Qs as a function of price,
yield
• 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
• 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 gov’t borrowing
• Increase in bond supply
• Bond supply shifts right
P
S
S’

Qs
• a change in business conditions
 affects incentives to expand production

exp. supply of
profits bonds
(shift rt.)
 exp. economic expansion shifts bond supply rt.
• a change in expected inflation
 rising inflation decreases real cost of borrowing

exp. supply of
inflation bonds
(shift rt.)
Bond Demand

• bond buyers/ lenders/ savers


• look at Qd as a function of bond
price/yield
Bond Qd of
yield bonds

price Qd of
of bond bonds

• so bond demand slopes down with


respect to price
Bond
price

Quantity of bonds
• 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

D
D
Qd
• a change in expected inflation
 rising inflation decreases real
return

inflation demand for


expected bonds
to (shift left)
• a change in exp. interest rates
 rising interest rates decrease value
of existing bonds

int. rates demand for


expected bonds
to (shift left)
• a change in the risk of bonds relative
to other assets

relative demand for


risk of bonds
bonds (shift left)
• a change in liquidity of bonds
relative to other assets

relative demand for


liquidity bonds
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
• 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
Why shift Bs > shift Bd?

• changes in wealth are small


• response to change in exp. profits is
large
 large cyclical swings in investment
• interest rate is pro-cyclical
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 U.S. gov’t debt
• Other issuers: corporate, municipal,
foreign have some default risk
• Greater default risk means a greater
yield
Inflation risk

• Most bonds promise fixed dollar


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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