Interest Rate Theory FNCE 4070 Financial Markets and Institutions

Bond Return The return on a bond is determined by: – The price paid for the bond. – The length of time that the bond is held - the holding period – The coupons received on the bond – The interest rate received on the coupons to the date that the bond is held – The price when the bond is sold. Note, when the bond is held to maturity the price at which the bond is “sold” is the principal plus final interest payment

Bond Return Risks Reinvestment Risk – What yield can one achieve on cashflows received during the holding period. Generally one assumes that this is the same as the yield on the bond (one reinvests the cashflows by buying more bonds) Interest Rate Risk – What will be the yield to maturity on the bond at the end of the holding period.

Asset Demand An asset is a piece of property that is a store of value. Facing the question of whether to buy and hold an asset or whether to buy one asset rather than another, an individual must consider the following factors: 1.Wealth, the total resources owned by the individual, including all assets 2.Expected return (the return expected over the next period) on one asset relative to alternative assets 3.Risk (the degree of uncertainty associated with the return) on one asset relative to alternative assets 4.Liquidity (the ease and speed with which an asset can be turned into cash) relative to alternative assets

Expected Return The Expected Return of an asset is defined as Holding everything else constant increasing the expected return of an asset increases the demand for that asset.

Risk A simple measure of risk is the standard deviation of the expected return Holding everything else constant increasing the risk of an asset will reduce its demand.

Liquidity Liquidity describes how quickly an asset can be converted into cash at a low cost. – A house might be considered a very illiquid asset – very high transaction costs (realtor fees, lawyer fees etc) and it takes time to find a buyer. – A US Treasury Bill is a highly liquid instrument. Leaving everything else constant an asset with greater liquidity will have greater demand.

Summary of Asset Demand

Bond Supply Factors that will affect the bond supply include: 1.Expected Profitability of Investment Opportunities: in a business cycle expansion, the supply of bonds increases, conversely, in a recession, when there are far fewer expected profitable investment opportunities, the supply of bonds falls 2.Expected Inflation: an increase in expected inflation causes the supply of bonds to increase 3.Government Activities: higher government deficits increase the supply of bonds, conversely, government surpluses decrease the supply of bonds

Market Equilibrium When the quantity of bonds supplied equals the quantity of bonds demanded.