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Interest Rate Fluctuations

Chapters 5

Learning Objectives

• Understand why bond prices and interest rates move in the opposite direction

• Describe the structure of TIPS

• Use supply and demand analysis to explain the effect of various events on the interest rate

• Use supply and demand analysis to explain the Fisher effect.

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Relationship Between Price and Yield to Maturity

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TIPS (Treasury Inflation Protection Securities)

• Originally issued in 1997.

• Interest and principal payments are adjusted for inflation.

• In times of high inflation the $ amount paid to investors rises.

• Return on TIPS relative to regular Treasurys provides information on expected inflation.

Yields on 1-month T-bills2001-2008

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“The” Interest Rate: averaging across risk and maturity

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“The” Interest Rate: averaging across risk and maturity

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“The” Interest Rate: averaging across risk and maturity

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Economists can’t predict …

… but they can explain after the fact.

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Supply and Demand of Bonds

Supply: borrowers (issuers of bonds)

Demand: lenders (buyers of bonds)

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N=1, FV=1000

Price (PV) Yield (I/Y)

750

800

850

900

950

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N=1, FV=1000

Price (PV) Yield (I/Y)

750 33.33

800 25.00

850 17.65

900 11.11

950 5.26

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Supply and Demand

Analysis ofthe Bond Market

Movement along the curve

Versus

Shifts of the curve

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Shift Factors for the Demand for Bonds

• Wealth

• Expected return

• Expected interest rate

• Inflationary expections

• Relative Risk

• Relative Liquidity

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Shifts in the Bond Demand Curve

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1. Profitability of Investment Opportunities

Business cycle expansion, investment opportunities , Bs , Bs shifts out to right

2.Expected Inflation

e , Bs , Bs shifts out to right

3.Government Activities

Deficits , Bs , Bs shifts out to right

Shift Factors for Supply of Bonds

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Shifts in the Bond Supply Curve

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Changes in e: the Fisher Effect

If e 1. Bd shifts in to

left2. Bs , Bs shifts

out to right3. P , i

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• What will happen to bond prices if stock trading commissions decrease? Why?

• What will happen to bond prices if bond trading commissions increase? Why?

• What will happen to bond prices if the government implements tax increases? Why?

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• If government revenues drop significantly (and remember all else stays the same, including government expenditures), what will likely happen to bond prices? Why?

• If the government guaranteed the payment of bonds, what would happen to their prices? Why?

• What will happen to bond prices if the government implements regulatory reforms that reduce regulatory costs for businesses? Why?

• If government revenues increase significantly, what will likely happen to bond prices? Why?

• What will happen to bond prices if terrorism ended and the world’s nations unilaterally disarmed and adopted free trade policies? Why?

• What will happen to bond prices if world peace brought substantially lower government budget deficits?

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Changes in the money supply

Two effects:

The initial effect of more money to invest lowers the interest rate, but if market participants expect inflation then the Fisher effect will cause the interest rate to increase.

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