Economics Chapter: Interest Rates and Bonds

Interest Rates and Present Value

• A promise to receive $100 in one year, when the interest rate is zero, is equal in value to receiving $100 today.

• Present value is higher when the future value of the payment is higher, the time until payment is shorter, and the interest rate is lower.

Bond Market Supply and Demand

• The Demand and Supply equations for the bond market are:
  • Demand: Qd = 1,000 – 6P/5
  • Supply: Qs = P – 100
  • At a price of $400, there would be an excess supply of bonds.

Economic Growth and Interest Rates

• A period of robust economic growth typically leads to an increase in the term spread, as investors become more optimistic about future economic prospects.

Inflation Expectations and Bond Yields

• When expected inflation increases, for any given nominal interest rate, the yield on bonds will increase.

Factors Affecting Bond Supply

• An increase in government spending relative to revenue can lead to an increase in bond supply.

Impact of Expected Returns on Bond Demand

• If expected return on bonds falls relative to other assets, the bond demand curve will shift to the left.

Business Conditions and Bond Market

• A deterioration in business conditions that also causes a decrease in a nation's wealth will lead to a leftward shift in both bond demand and bond supply.
• The impact on bond prices will be ambiguous since both the bond demand and supply curves shift left.

Interest-rate Risk

• Interest-rate risk refers to the risk that the market value of a bond will change due to fluctuations in interest rates.
• Individuals owning long-term bonds are exposed to greater interest-rate risk.

Federal Reserve Interest Rate Policy and the Bond Market

• If the Federal Reserve is expected to raise interest rates, this will likely lead to a decrease in bond prices and an increase in yields.

Long-Term Economic Growth and the Bond Market

• If an economy continues to grow at robust rates for a long period of time, the demand for bonds will likely increase, driving down yields and increasing bond prices.

Bond Ratings and Market Demand

• If a bond's rating improves, the demand for the bond will increase, and the yield will decrease.

Taxable Bond Returns

• Fatima will pay $4 in taxes on her bond investment.
• The return on the investment after taxes will be 4%.

Bond Yield to Maturity

• If a bond's yield to maturity is less than its coupon rate, the bond was likely purchased at a premium.