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# Chapter 06 - Bonds, Bond Prices, and the Determination of Interest Rates

Chapter 6
Bonds, Bond Prices, and the Determination of Interest
Rates
Chapter Overview

If we want to understand the financial system, particularly the bond market, we must
understand the relationship between bond prices and interest rates, the determination of
bond prices in the market (by supply and demand), and also why bonds are risky. These
issues will be covered in this chapter.

## Reading this chapter will prepare students to:

Calculate the value of a bond by applying present value techniques.
Assess the yields on bonds with different characteristics.
Explain changes in the supply of and demand for bonds and their attendant effects
on the bond market.
Define the three types of risk associated with bonds (default risk, inflation risk,
and interest-rate risk).

## Important Points of the Chapter

Any financial arrangement involving the current transfer of resources from a lender to a
borrower, with a transfer back at some time in the future, is a form of a bond. The ease
with which individuals, corporations, and governments borrow is essential to the
functioning of our economic system. While the depth and complexity of bond markets
has increased in modern times, many of their original features (dating back to the 16th and
17th centuries) remain.

## Application of Core Principles

Principle #1: Time. The price of a Treasury bill is the present value of the future
payments it will make. The shorter the time period until the payments are made, the
higher the price of the bond.

Principle #4: Markets. Equilibrium in the bond market occurs when supply and demand
are equal. At a higher price there would be an excess supply of bonds, which would push
the price down. At a lower price there would be an excess demand for bonds, which
would push the price up. Only when supply and demand are equal can there be
equilibrium.

Principle #2: Risk. Risk arises from the fact that an investment has many possible payoffs
during the time horizon for which it is held. Certain risks affect the premium that
investors require over the risk-free return. Risk requires compensation.

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Chapter 06 - Bonds, Bond Prices, and the Determination of Interest Rates

## Teaching Tips/Student Stumbling Blocks

This chapter continues the use of present value analysis to analyze how bond
prices are determined. You may wish to begin with a review of the tools from
Chapter 5.
Spend time going carefully through the examples from the text and reinforce
concepts by assigning end-of-chapter problems.

## Features in this Chapter

A large number of people with adjustable rate mortgages (ARMs) underestimate how
much the interest rate can change. Important things to know are what interest-rate index
the mortgage rate is based; how big is the mortgage rate margin above the interest-rate
index on which it is based; how frequently the rate is adjusted; does it have an initial
discount rate that will rise, and by how much; whether there is a cap on how much the
rate can rise both at one adjustment and over the life of the loan; whether there is a
payment cap, and, if the payment cap is reached, will the principal amount of the loan
then increase (this is negative amortization); and finally, whether it can be converted to a
fixed-rate mortgage.

This section illustrates and explains how to read a bond table. The U.S. Treasury alone
had more than 200 coupon-bearing instruments outstanding. The table shows that the
yields on government bonds vary significantly over time and substantially across
countries. Also, the latest 10-year yield exceeded the latest two-year yield in every
country, and the yield on each bond differs from its coupon rate. Thousands of
corporations issues bonds, as well.

Suppose you see an ad for an investment company stating that their bond mutual funds
returned 13.5% over the last year. How is this possible if interest rates have been pretty
rates were falling. The resulting rise in bond prices (due to the falling rates) meant the
return was more than just the interest paid by the bonds; it also included capital gains. In
a rising interest rate environment the holding period return will be negatively affected by
decreases in bond prices. Thats one reason why past performance is indeed not an
indicator of future returns.

## Applying the Concept: When Russia Defaulted

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On numerous occasions, investors concerns about increased risk in certain areas of the
globe have led to a significant shift in the demand for U.S. Treasury bonds. The default
by the Russian government in the fall of 1998 was such an occasion. As a result of the
default no one wanted to hold Russian debt or, for that matter, the debt of any emerging
market country, and so the demand for safe U.S. Treasury bonds increased. The prices of
U.S. Treasuries rose and their yields fell as their perceived riskiness declined.

## Applying the Concept: Securitization

Securitization is the process by which financial institutions pool various assets that
generate a stream of payments and transform them into a bond that gives the bondholder
a claim on those payments. Mortgage-backed securities are just one form of
securitization. Any stream of payments can be used to create a bond. Securitization uses
the effiency of markets to lower the cost of borrowing by facilitating diversification of
risk, making assets liquid, allowing greater specialization in the business of finance,

## Your Financial World: Bonds Guaranteed to Beat Inflation (page 141)

There is a type of U.S. Treasury bond that compensates investors for inflation. The bond
promises to pay a fixed interest rate plus the change in the consumer price index. The
U.S. Treasury sells two types of such bonds, Series I savings bonds and Treasury
Inflation Protection Securities (or TIPS). The difference between the two is the amount
that can be purchased (savings bonds can be bought for as little as \$50, while TIPS
require a \$1000 investment).

## In the News: Revival in Private-Label Mortgage Securities

Recently, some underwriters on Wall Street are discussing the possibility of bringing
private-label mortgage securities to market. Most mortgages historically were backed by
Fannie Mae or Freddie Mac and the Federal Housing Administration. During the housing
boom, investment and mortgage banks entered the market and began issuing mortgage-
backed securities. At the peak of the housing market, private-label mortgage securities
accounted for 56% of the \$2 trillion in mortgage securities sold to investors. Virtually all
mortgage securities are now backed by the government agencies, and demand is low.
One factor limiting the market for private-label MBSs is the fact that few lenders are
originating large numbers of mortgages.

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## Lessons of the Article: Private securitization of mortgages

securitization that does not involve government agency guarantees
surged in the U.S. housing boom from 2003 to 2006, and the
securities were increasingly backed by risky mortgages. When the
boom in house prices ended, holders of the private-label securities
suffered large losses, and in the resulting financial crisis that hit in
2007, private securitization of mortgages collapsed. The article
reports that, as of early 2010, it had yet to rebound, and although
some underwriters were seeing an opportunity to revive it, many
obstacles remained.

In an article from Business Week (Bonds: Sorting Through the Confusion, January 6,
2010), David Bogoslaw writes, Getting your investment portfolio's bond allocation right
will not be easy in 2010 amid conflicting views on inflation from investment strategists
and policymakers. Many experts are watching inflation on the fear that the Fed will not
withdraw the massive amounts of money in the economy as it begins to heat up.
However, these experts are not convinced that January was the time to enter the TIPS
market, as the payoff was not yet worth moving.

Virtual Tools

Use the withholding calculator on the IRS website to adjust the amount taken from your
paycheck. It is located at www.irs.gov.

Visit the web site of the Treasury to see how Series I and TIPS can be purchased; it is
located at http://www.publicdebt.treas.gov.

## For More Discussion

Joan Robinson once stated that anyone who bought an infinite-maturity consol would
have to think he knows exactly what the rates of interest will be every day from now to
Kingdom Come. Relate this to the discussion of interest rate risk in this chapter.

(Source: Robinson, Joan, "The Rate of Interest," Econometrica 19 (1951): 92-111; she
was objecting to the version of the Expectations Hypothesis that relates forward interest
rates to expectations of future short term interest rates. This will be covered in more
detail in Chapter 7.)

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Chapter Outline

I. Bond Prices
There are four basic types of bonds: zero-coupon bonds, which promise a single
future payment (like a U.S. Treasury Bill); fixed payment loans (like conventional
mortgages); coupon bonds, which make periodic interest payments and repay the
principal at maturity (like U.S. Treasury Bonds and most corporate bonds); and
consols, which make periodic interest payments but never repay the principal that was
borrowed. In this section we will see how each of these is priced.
A. Zero-Coupon Bonds
1. These are pure discount bonds (also called discount bonds) since they sell at a
price below their face value.
2. The difference between the selling price and the face value represents the
interest on the bond.
3. The price of such a bond, like a Treasury bill (called T-bill), is the present
value of the future payment.
4. The most common maturity of a T-bill is 6 months; the Treasury does not
issue them with a maturity greater than 1 year.
5. The shorter the time until the payment is made the higher the price of the
bond, so 6 month T-bills have a higher price that a one-year T-bill.
6. The interest rate and the price for the T-bill move inversely. If we know the
face value and the price then we can solve for the interest rate.
B. Fixed Payment Loans
1. Home mortgages and car loans are examples of fixed payment loans; they
promise a fixed number of equal payments at regular intervals.
2. These loans are amortized, meaning that the borrower pays off the principal
along with the interest over the life of the loan. Each payment includes both
interest and some portion of the principal.
3. The price of the loan is the present value of all the payments.
C. Coupon Bonds
1. The value of a coupon bond is the present value of the periodic interest
payments plus the present value of the principal repayment at maturity.
2. The latter part, the repayment of the principal, is just like a zero-coupon bond.
D. Consols
1. A consol offers only periodic interest payments; the borrower never repays the
principal.

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2. There are no privately issued consols because only governments can credibly
promise to make payments forever.
3. The price of a consol is the present value of all the future interest payments,
which is a bit complicated because there are an infinite number of payments.
II. Bond Yields
A. Yield to Maturity
1. The most useful measure of the return on holding a bond is called the yield to
maturity. This is the yield bondholders receive if they hold the bond to its
maturity when the final principal payment is made.
2. The yield to maturity can be calculated from the present value formula.
3. If the yield to maturity equals the coupon rate, the price of the bond is the
same as its face value. If the yield is greater than the coupon rate, the price is
lower; if the yield is below the coupon rate, the price is greater.
4. If you buy a bond at a price less than its face value you will receive its interest
and a capital gain, which is the difference between the price and the face
value. As a result you have a higher return than the coupon rate.
5. When the price is above the face value, the bondholder incurs a capital loss
and the bonds yield to maturity falls below its coupon rate.
B. Current Yield
1. Current yield is a commonly used, easy-to-compute measure of the proceeds
the bondholder receives for making a loan.
2. It is the yearly coupon payment divided by the price.
3. The current yield measures that part of the return from buying the bond that
arises solely from the coupon payments; it ignores the capital gain or loss that
arises when the bonds price differs from its face value.
4. The current yield moves inversely to the price; if the price is above the face
value, the current yield falls below the coupon rate. When the price falls
below the face value, the current yield rises above the coupon rate. If the
price and the face value are equal the current yield and the coupon rate are
equal.
5. Since the yield to maturity takes account of capital gains (and losses), when
the bond price is less than its face value the yield to maturity is higher than the
current yield, and if the price is greater than face value, the yield to maturity is
lower than the current yield, which is lower than the coupon rate.
C. Holding Period Returns
1. The investors return from holding a bond need not be the coupon rate.
2. Most holders of long-term bonds plan to sell them well before they mature,
and because the price of the bond may change in the time since its purchase,
the return can differ from the yield to maturity.

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3. The greater the price change the more important the capital gain or loss
becomes as part of the holding period return.
4. The longer the term of the bond, the greater the price movements and
associated risk can be.
III. The Bond Market and the Determination of Interest Rates
To find out how bond prices are determined and why they change we need to look
at the supply and demand in the bond market. Lets discuss the quantity of bonds
outstanding (the stock of bonds) and consider bonds prices rather than interest rates.
The analysis will consider the one-year zero-coupon bond.

## A. Bond Supply, Bond Demand, and Equilibrium in the Bond Market

1. The bond supply curve is the relationship between the price and quantity of
bonds people are willing to sell, all other things being equal.
2. The bond supply curve is upward sloping; the higher the price of a bond, the
larger the quantity supplied will be because investors will be tempted to sell
bond that they hold and companies will find it advantageous to issue new
bonds.
3. The bond demand curve is the relationship between the price and quantity of
bonds that investors demand, all other things being equal.
4. The bond demand curve slopes down; as the price falls, the reward for
holding the bond rises so there is a greater quantity demanded.
5. Equilibrium in the market is the price at which the quantity demanded
equals the quantity supplied of bonds.
6. If the price is too high (above equilibrium) the excess supply of bonds will
push the price back down. If the price is too low (below equilibrium) the
excess demand for bonds will push it up.
7. Over time the supply and demand curves can shift, leading to changes in the
equilibrium price.
B. Factors that Shift Bond Supply
1. We can identify the factors that shift the supply curve for bonds:
a. Changes in government borrowing: the more governments borrow the
greater the quantity of bonds supplied, shifting the curve to the right.
investment opportunities, prompting firms to increase their borrowing
and increasing the quantity of bonds supplied. By the same logic, weak
economic growth can lead to rising bond prices and lower interest rates.
c. Changes in expected inflation: bond issuers care about the real cost of
borrowing, so if inflation is expected to increase then the real cost falls

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and the desire to borrow rises, resulting in the bond supply curve shifting
to the right.
d. Changes in corporate taxation: changes in the tax code are infrequent,
but when they occur they affect the quantity of bonds supplied. Tax
incentives that make investment less costly increase the quantity of
bonds supplied.
C. Factors that Shift Bond Demand
1. Six factors shift the demand for bonds:
a. Wealth: increases in wealth shift the demand for bonds to the right as
wealthier people invest more.
b. Expected inflation: a fall in expected inflation will shift the demand for
bonds to the right.
c. The expected return on stocks and other assets: if the return on bonds
rises relative to the return on alternative investments, the demand for
bonds will shift to the right.
d. Expected interest rates: changes in expected interest rates affect bond
prices; if interest rates are expected to fall, then bond prices are expected
to rise, and the demand for bonds shifts to the right.
e. Risk relative to alternatives: if a bond is less risky then the demand will
shift to the right.
f. The liquidity of bonds relative to alternatives: the more liquid an asset
the higher its demand, shifting the demand curve to the right.
D. Understanding Changes in Equilibrium Bond Prices and Interest Rates
1. An increase in expected inflation shifts bond supply to the right and bond
demand to the left. The two effects reinforce each other, resulting in a lower
bond price and a higher interest rate.
2. A business-cycle downturn shifts the bond supply to the left and the bond
demand to the left. In this case the bond price can rise or fall, depending on
which shift is greater. But interest rates tend to fall in recessions, so bond
prices are likely to increase.
IV. Why Bonds Are Risky
Bondholders face three major risks:
A. Default Risk
1. There is no guarantee that a bond issue will make the promised payments.
2. Investors who are risk averse require some compensation for bearing risk;
the more risk, the more compensation they demand.
3. The higher the default risk the higher the probability that bondholders will
not receive the promised payments and thus, the higher the yield.

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B. Inflation Risk
1. Bonds promise to make fixed-dollar payments, and bondholders are
2. The nominal interest rate will be equal to the real interest rate plus the
expected inflation rate plus the compensation for inflation risk.
3. The greater the inflation risk, the larger will be the compensation for it.
C. Interest-Rate Risk
1. Interest-rate risk arises from the fact that investors dont know the holding
period yield of a long-term bond.
2. If you have a short investment horizon and buy a long-term bond you will
have to sell it before it matures, and so you must worry about what happens
if interest rates change.
3. Because the price of long-term bonds can change dramatically, this can be
an important source of risk.

## Terms Introduced in Chapter 6

capital gain
capital loss
consol or perpetuity
current yield
default risk
holding period return
inflation risk
inflation-indexed bonds
interest-rate risk
investment horizon
U.S. Treasury bill (T-bill)
yield to maturity
zero-coupon bond

Lessons of Chapter 6

## 1. Valuing bonds is an application of present value.

a. Pure discount or zero-coupon bonds promise to make a single payment on a
predetermined future date.
b. Fixed-payment loans promise to make a fixed number of equal payments at
regular intervals.
c. Coupon bonds promise to make periodic interest payments and repay the principal
at maturity.

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Chapter 06 - Bonds, Bond Prices, and the Determination of Interest Rates

## 2. Yields are measures of the return on holding a bond.

a. The yield to maturity is a measure of the interest rate on a bond. To compute it,
set the price of the bond equal to the present value of the payments.
b. The current yield on a bond is equal to the coupon rate divided by the price.
c. When the price of a bond is above its face value the coupon rate is greater than
the current yield, which is higher than the yield to maturity.
d. One-year holding period returns are equal to the sum of the current yield and any
capital gain or loss arising from a change in a bonds price.

3. Bond prices (and bond yields) are determined by supply and demand in the bond
market.
a. The higher the price, the larger the quantity of bonds supplied.
b. The higher the price, the smaller the quantity of bonds demanded.
c. The supply of bonds rises when
i. Governments need to borrow more.
iii. Expected inflation rises.
d. The demand for bonds rises when
i. Wealth increases.
ii. Expected inflation falls.
iii. The expected return, relative to other investments, rises.
iv. The expected future interest rate falls.
v. Bonds become less risky, relative to other investments.
vi. Bonds become more liquid, relative to other investments.

## 4. Bonds are risky because of

a. Default risk: the risk that the issuer may fail to pay.
b. Inflation risk: the risk that the inflation rate may be more or less than expected,
affecting the real value of the promised nominal payments.
c. Interest Rate Risk: the risk that the interest rate might change, causing the bonds
price to change.

Conceptual Problems

1. Consider a U.S. Treasury Bill with 270 days to maturity. If the annual yield is 3.8
percent, what is the price?

\$100
(1 0.038) 9 / 12

2. Which of these \$100 face value one-year bonds will have the highest yield to maturity
and why?

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## a. 6 percent coupon bond selling for \$85.

b. 7 percent coupon bond selling for \$100.
c. 8 percent coupon bond selling for \$115.

\$6 \$100
a. \$85 i 24.71%
1 i 1 i

\$7 \$100
b. \$100 i 7%
1 i 1 i

\$8 \$100
c. \$115 i 6.1%
1 i 1 i
Option (a.) has the highest yield to maturity. The yield to maturity depends both on
the coupon payment and any capital gain or loss arising from the difference between
the selling price and the face value of the bond. While (a.) has the lowest coupon
rate, it is selling below face value, and so there is a capital gain. Option (b.) is selling
at face value, so there is no capital gain and option (c.) is selling above face value and
so there is a capital loss. As the calculations above show, the combination of the
coupon payment and the capital gain on option (a.) produces the highest yield to
maturity.

3. You are considering purchasing a consol that promises annual payments of \$4.
a. If the current interest rate is 5 percent, what is the price of the consol?
b. You are concerned that the interest rate may rise to 6 percent. Compute the
percentage change in the price of the consol and the percentage change in the
interest rate. Compare them.
c. Your investment horizon is one year. You purchase the consol when the interest
rate is 5 percent and sell it a year later, following a rise in the interest rate to 6
percent. What is your holding period return?

\$4
a. P \$80
0.05

\$4
b. newP \$66.67
0.06

## P falls by 16.7%; i rises by 20%

\$4 \$66.67 \$80
c. 11 .7%
\$80 \$80

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Chapter 06 - Bonds, Bond Prices, and the Determination of Interest Rates

4. *Suppose you purchase a 3-year, 5-percent coupon bond at par and held it for two
years. During that time, the interest rate falls to 4%. Calculate your annual holding
period return.

Answer: The total holding period return over the two years consists of two coupon
payments of \$5 each plus the capital gain from the rise in the price of the bond due to
the interest rate fall.
The price at which you sell the bond after two years will be 5/1.04 +100/1.04 =

\$100.96.

Holding period return over two years= 10/100 +100.96-100/100 = .1096 or 10.96%
The total payoff on the bond for which you paid \$100 is \$110.96
To calculate the annual rate of return, we use the formula from chapter 4.
[(110.96/100)1/2 1] = .0534 or 5.34%.
Because the interest rate fell during the holding period and you made a capital gain,
the annual holding period return is higher than the coupon rate.

## 5. In a recent issue of the Wall Street Journal (or on www.wsj.com or an equivalent

financial Web site), locate the prices and yields on U.S. Treasury issues. For one bond
selling above par and one selling below par (assuming they both exist), compute the
current yield and compare it to the coupon rate and the ask yield printed in the paper.

## Answer: (From the February 19, 2010 Wall Street Journal)

yield=1.8168%
Current yield = \$4.25/\$108.71875 = 3.91%
Price>Par value: coupon rate>current yield>ask yield

b. \$100, 1.5% bond maturing Dec 31 2013: ask price=\$98 11/32, ask
yield=1.9502%
Current yield = \$1.50/\$98.34375 = 1.53%
Price<Par value: coupon rate<current yield<ask yield

6. In a recent issue of the Wall Street Journal (or on www.wsj.com), locate the yields on
Government bonds for various countries. Find a country whose 10-year Government
bond yield was above that on the US 10-year Treasury bond and one whose 10-year
yield was below the Treasury yield. What might account for these differences in
yields?

## Answer: (From February 23, 2010, Wall Street Journal)

The yield on the 10-year US Treasury bond was 3.689% while the Australian 10-year
Government bond yield was 5.590% and the Canadian 10-year Government bond
yield was 3.435%.

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Chapter 06 - Bonds, Bond Prices, and the Determination of Interest Rates

## Differences in yields across countries likely reflect differences in expected inflation in

those countries. They may also reflect differences in the required compensation for
risk associated with bonds from different countries.

## 7. A 10-year zero-coupon bond has a yield of 6 percent. Through a series of unfortunate

circumstances, expected inflation rises from 2 percent to 3 percent.
a. Compute the change in the price of the bond.
b. Suppose that expected inflation is still 2 percent, but the probability that it will
move to 3 percent has risen. Describe the consequences for the price of the bond.

a. Price (with 2% expected inflation) = 100/(1.06)10 = \$55.84
Price (with 3% expected inflation) = 100/(1.07)10 = \$50.83
The price has fallen by \$5.01

b. There is increased inflation risk. Investors will require compensation for taking
on additional risk, so the price will fall and the yield will rise.

mutual fund a fund that pools the investments from a large number of people and
then purchases bonds, giving the individuals shares in the fund. The company
claims their fund has had a return of 13 percent over the last year. But you
remember that interest rates have been pretty low 5 percent at most. A quick
check of the numbers in the business section youre holding tells you that your
recollection is correct. Explain the logic behind the mutual funds claim in the

Answer: There are two possible explanations for the high return. The first is that
the mutual fund is investing in relatively risky bonds and is being compensated for
taking on this risk with higher returns. The second is that the fund was holding
bonds during a period when interest rates were falling, so the holding period return
far exceeded the interest rate.
Remember that when interest rates fall, the prices of bonds rise, giving the owner a
capital gain. If interest rates are now low, then the likelihood is that they will rise,
causing a capital loss to the owners. Chances are that the high return is a
consequence of the interest rate decline, so not only will it not be repeated, it is
likely to be followed by a low or even negative return when interest rates rise.

9. You are sitting at the dinner table and your father is extolling the benefits of
investing in bonds. He insists that as a conservative investor he will only make
investments that are safe, and what could be safer than a bond, especially a U.S.
Treasury bond? What accounts for his view of bonds, and explain why you think
it is right or wrong?

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means that he will get his investment back. Hes right that the U.S. Treasury is
extremely unlikely to default, so there is virtually no default risk. But hes wrong
about interest-rate and inflation risk. The value of the bond will fluctuate when the
interest rate changes (moving inversely) and the purchasing power of the coupon
and principal repayment will fluctuate with inflation. So, the bond is not risk free.

10. *Consider a one-year, 10-percent coupon bond with a face value of \$1,000 issued
by a private corporation. The one-year risk-free rate is 10%. The corporation has
hit on hard times, and the consensus is that there is a 20% probability that it will
default on its bonds. If an investor were willing to pay \$775 for the bond, is that
investor risk-neutral or risk averse?

Answer: If the bond were risk free, it would pay off \$1100 in one years time - \$100
coupon payment and \$1000 face value of the bond.
If there is a 20% risk of default, then the expected value of these payment flows
associated with the bond are \$1100 *.8 + 0*.2 = \$880
The present value of \$880 in one years time is \$880/1.1 = \$800. This would be the
price a risk-neutral investor would be willing to pay.
If the investor is only willing to pay \$775 for the bond, he or she requires
compensation for bearing the risk associated with the bond and so is risk averse.

Analytical Problems

11. If, after one year, the yield to maturity on a multi-year coupon bond that was
issued at par is higher than the coupon rate, what happened to the price of the bond
during that first year?

Answer: The price of the bond fell below par. When a bond is at par, the yield to
maturity equals the coupon rate. If the yield to maturity rises, the price of the
bond falls. If you buy the bond below par, the capital gain you receive by holding
it to maturity is included along with the coupon payments in the yield to maturity
and so it is higher than the coupon rate alone.

12. Use your knowledge of bond pricing to explain under what circumstances you
would be willing to pay the same price for a consol that pays \$5 a year forever and
a 5-percent, 10-year coupon bond with a face value of \$100 that only makes
annual coupon payments for 10 years.

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Chapter 06 - Bonds, Bond Prices, and the Determination of Interest Rates

Answer: The price you are willing to pay for a bond reflects the present value of
the payment flows from the bond. In this case, if i = 5%, the present value of the
payment flows for both these bonds would be \$100. Intuitively, while the consol
makes coupon payments forever, the 10-year coupon bond pays back the principal
at maturity, which then can be reinvested.

adjustable-rate mortgages (ARMs). The interest rate on the ARM is lower than
that on a fixed rate mortgage. The advertisement mentions that there would be a
payment cap on your monthly payments and you would have the option to convert
to a fixed-rate mortgage. You are tempted. Interest rates are currently low by
historical standards and you are anxious to buy a house and stay in it for the long
term. Why might an ARM not be the right mortgage for you?

Answer: There are several factors to consider. First, with a fixed rate mortgage, your
payments are fixed over the life of the loan. The interest rate is higher because the
lender is assuming the interest rate risk. The ARM has a lower interest rate in part
because you will assume risk associated with interest rate movements over the life of
the loan.
Given that interest rates are currently relatively low, it is more likely that they will
rise, pushing up your payments. This problem is more likely to be an issue the longer
you plan to stay in the house.
Converting to a fixed-rate mortgage often involves restrictions and fees.
Payment caps may limit how much your monthly payments can rise, but may be
associated with negative amortization if your payments dont cover the interest

14. Use the model of supply and demand for bonds to illustrate and explain the impact
of each of the following on the equilibrium quantity of bonds outstanding and on
equilibrium bond prices and yields:
i) A new Web site is launched facilitating the trading of corporate bonds with
much more ease than before.
ii) Inflationary expectations in the economy fall evoking a much stronger
response from issuers of bonds than investors in bonds
iii) The government removes tax incentives for investment and spends
additional funds on a new education program. Overall, the changes have
no affect on the governments financing requirements.
iv) All leading indicators point to stronger economic growth in the near
future. The response of bond issuers dominates that of bond purchasers.

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Chapter 06 - Bonds, Bond Prices, and the Determination of Interest Rates

i) The new web site would increase the relative liquidity of bonds,
shifting the bond demand curve to the right, increasing the equilibrium
price of bonds and reducing yields. The equilibrium quantity of bonds
outstanding rises.

S
Price of Bonds

P1

P0

D1
D0

Q0 Q1
Quantity of Bonds

## ii) For a given nominal interest rate, a fall in inflationary expectations

increases the real interest rate, shifting the bond supply curve to the left
and the bond demand curve to the right. If the response of the bond
issuers is relatively stronger, the supply curve shift will dominate and the
quantity of bonds outstanding will fall. Regardless of the relative size of
the shifts, the equilibrium price of bonds will rise and yields will fall.

S1
S0
Price of Bonds

P1

P0

D0 D1

Q1 Q0
Quantity of Bonds

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Chapter 06 - Bonds, Bond Prices, and the Determination of Interest Rates

## iii) The removal of tax incentives on investment would make investment

more costly, reducing the supply of bonds by corporations and shifting the
supply curve to the left. As there is no change in the financing
requirements of the government, the supply of government bonds doesnt
change. Equilibrium quantity falls. Equilibrium bond prices rise and
yields fall.

S1
S0
Price of Bonds

P1

P0

D0
Q1 Q0
Quantity of Bonds

shifting the bond supply curve to the right. Wealth also increases, shifting
the bond demand curve to the right. If the supply shift dominates,
equilibrium bond prices fall and yields rise. The equilibrium quantity of
bonds outstanding increases.

S0
S1
Price of Bonds

P0
P1

D0 D1
Q0 Q1
Quantity of Bonds

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Chapter 06 - Bonds, Bond Prices, and the Determination of Interest Rates

15. Suppose sustainable peace is reached in Iraq and Afghanistan, reducing military
spending by the U.S. Government. How would you expect this development to
affect the U.S. bond market?

Answer: As the governments need to issue bonds to finance the wars is reduced,
supply of government bonds will fall, shifting the supply curve to the left. Bond
prices will increase and yields will fall.

S1
S0
Price of Bonds

P1

P0

D0
Q1 Q0
Quantity of Bonds

16. Use the model of supply and demand for bonds to determine the impact on bond
prices and yields of expectations that the real estate market is going to weaken.

## Answer: If we think of real estate as an alternative investment to bonds, expected

weakness in the real estate market implies an increase in the relative return on bonds.
Bond demand shifts to the right, increasing the equilibrium bond prices and lowering
yields.

S
Price of Bonds

P1

P0

D1
D0

Quantity of Bonds

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Chapter 06 - Bonds, Bond Prices, and the Determination of Interest Rates

17. *Suppose there is an increase in investors willingness to hold bonds at a given price.
Use the model for the demand and supply of bonds to show that the impact on the
equilibrium bond price depends on how sensitive the quantity supplied of bonds is to
the bond price.

Answer: The sensitivity of bond supply to changes in the price of bonds is reflected in
the slope of the supply curve. The more sensitive quantity supplied is to a movement
in the price, the flatter the supply curve and the smaller the impact on the equilibrium
price for any given shift in the demand curve.

S
Price of Bonds

Price of Bonds
S
P1
P1
P0 P0

D1 D1
D0 D0

## Quantity of Bonds Quantity of Bonds

18. Under what circumstances would purchasing a Treasury Inflation Protected Security
(TIPS) security from the U.S. government be virtually risk free?

## Answer: Purchasing a Treasury Inflation Protected Security (TIPS) security would be

virtually risk free if you purchased a bond whose maturity exactly matched your
investment horizon. The default risk of holding a U.S. government-issued bond is
negligible while inflation risk is eliminated by the inflation-indexed nature of the
TIPS. If you know your investment horizon with certainty and purchase a bond
whose maturity matches that horizon, you eliminate interest rate risk, as you know the
bond will be redeemed at par when it matures. Interest rate movements that cause
the price of the bond to change before it matures will not affect you.

19. In the wake of the financial crisis of 2007-2009, negative connotations often
surrounded the term mortgage-backed security. What arguments could you make
to convince someone that they may have benefitted from the growth in securitization
over the past 30 years?

Answer: If the person you are trying to convince is a borrower, they may have
received a lower mortgage interest rate due to the increased liquidity provided by

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Chapter 06 - Bonds, Bond Prices, and the Determination of Interest Rates

securitization. If they are from a small town, they may have found it easier to get a
mortgage as securitization broadened the potential sources of funds for their loan. If
they are an investor, you might point to the opportunities for diversification provided
by securitization.

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