30 Questions
What happens to the market value of an asset or liability when interest rates increase?
It reduces
What is the relationship between interest rate risk and market price risk?
They are inversely proportional
What is the risk that earnings from a financial asset need to be reinvested in lower-yielding assets?
Reinvestment risk
What is the uncertainty about the interest rate at which a company could reinvest funds borrowed for a longer period?
Reinvestment risk
What is the risk that the cost of rolling over or reborrowing funds could be more than the return earned on asset investments?
Refinancing risk
What should a financial intermediary aim to earn when reinvesting borrowed funds at an interest rate of 10%?
More than 10%
What happens when the return on investment is lower than the interest on borrowed funds?
The financial intermediary loses money.
What is the risk that a borrower might not be able to pay back a loan?
Default risk
Why do suppliers investigate the background of buyers?
To determine their creditworthiness.
What is the result of inflation on the purchasing power of money?
It decreases the purchasing power.
What is the consequence of rising gas prices?
Drivers can buy less gas with their money.
What is the risk associated with the increase in prices of goods and services?
Inflation risk
What happens to the equilibrium value of interest rates when one of the factors changes, causing a shift in the demand or supply curve?
There will be a new equilibrium value
What is the framework for deciding which factors cause the demand curve for bonds to shift?
The theory of asset demand
What is the effect of an increase in wealth on the demand curve for bonds?
The demand curve shifts to the right
What is the relationship between the economy's growth and the demand for bonds?
The economy's growth increases the demand for bonds
What is the effect of a change in expected returns on bonds relative to alternative assets on the demand curve for bonds?
The demand curve shifts to the right
What is the purpose of Table 4.2 in understanding the demand curve for bonds?
To summarize the effects of changes in various factors on the bond demand curve
What happens to the expected return on bonds when there is an increase in expected inflation?
It decreases
What is the effect of an increase in expected inflation on the demand for bonds?
It decreases
What happens to the demand for bonds when there is an increase in the riskiness of bonds?
It decreases
What is the effect of an increase in the volatility of prices in the stock market on the demand for bonds?
It increases
What is the effect of a rise in expected inflation on the real interest rate on bonds?
It decreases
What happens to the demand curve for bonds when there is an increase in the expected rate of inflation?
It shifts to the left
What happens to the demand for bonds when their liquidity increases?
It increases
What is the effect of increased liquidity of alternative assets on the demand for bonds?
It shifts the demand curve to the left
What was the result of the reduction of brokerage commissions for trading common stocks in 1975?
Decreased demand for bonds
What is one of the factors that can cause the supply curve for bonds to shift?
All of the above
What happens to a firm's willingness to borrow when it expects to make more profitable investments?
It increases
What is the purpose of Table 4.3?
To summarize the effects of changes in these factors on the bond supply curve
Study Notes
Interest Rate Risk and Market Price Risk
- When interest rates increase, the market value of assets and liabilities decreases
- When interest rates fall, the market value of assets and liabilities increases
- Securities decline in price when interest rates rise, and interest rate risk and market price risk go in opposite directions
Reinvestment Risk/Refinancing Risk
- Reinvestment risk arises when earnings from a financial asset need to be reinvested in lower-yielding assets or investments due to fallen interest rates
- Refinancing risk is the risk that the cost of rolling over or reborrowing funds could be more than the return earned on asset investments
Default/Credit Risk
- Default risk or credit risk is the risk that the borrower will be unable to pay interest on a loan or principal of a loan
- Credit investigators investigate the background of borrowers before companies or banks grant loans requested by borrowers
Inflation/Purchasing Power Risk
- Inflation risk or purchasing power risk is the risk of an increase in the value of goods and services, reducing the purchasing power of the currency
- When prices or inflation rise, purchasing power decreases
Shifts in the Demand for Bonds
- The demand curve for bonds shifts in response to changes in four parameters:
- Wealth
- Expected returns on bonds relative to alternative assets
- Risk of bonds relative to alternative assets
- Liquidity of bonds relative to alternative assets
Shifts in the Supply of Bonds
- The supply curve for bonds shifts in response to changes in three factors:
- Expected profitability of investment opportunities
- Expected inflation
- Government budget
Learn about the inverse relationship between interest rates and market values of assets and liabilities, and how changes in interest rates affect market prices.
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