Slides By John Dawson and Kevin Brady Bond Prices and Interest Rates Begin CoreEconomics, 2e Interactive Examples To navigate, please click the appropriate.

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Slides By John Dawson and Kevin Brady Bond Prices and Interest Rates Begin CoreEconomics, 2e Interactive Examples To navigate, please click the appropriate green buttons. (Do not use the arrows on your keyboard) Material from this presentation can be found in: Chapter 22

Answer Bond Prices and Interest Rates QUESTION 1: Suppose you bought a government perpetuity bond one year ago with a face value of $5,000 and an annual interest payment of $350. If market interest rates are now 6%, what is the new price of the bond? Explain why the price of the bond has changed. Interactive Examples

Bond Prices and Interest Rates ANSWER TO QUESTION 1: The formula for the price of a perpetuity bond is: Price of Bond = Interest Payment / Yield Price of Bond = $350 /.06 = $5, It is clear that the price of the bond has risen. Why? Because the original yield was 7%, which can be found by dividing the interest payment by the original price of the bond. ($350/$5000) =.07, or 7% Since bond prices and interest rates move in opposite directions, a fall in interest rates to 6% would increase the price at which you would be able to sell your bond. A higher price can be realized in the face of falling interest rates because other investments are now offering lower interest rates. Interactive Examples Next

Answer Bond Prices and Interest Rates QUESTION 2: Before you are able to sell your bond, suppose high budget deficits and a rising national debt cause rumors of the U.S. government defaulting on its debt. How would you expect these rumors to affect the interest rate on newly issued government bonds? How about the price at which you are now able to sell your bond? Interactive Examples

Bond Prices and Interest Rates ANSWER TO QUESTION 2: If the default risk on government bonds increases, a higher implied interest rate would now be required to encourage investors to purchase those bonds. Since interest rates and bond prices move in opposite directions, this development would imply a lower price at which you would now be able to sell your bond. Interactive Examples The End

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