2. After studying this chapter, you should be able to:
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
4.1
Discuss the most important factors in building an investment portfolio.
4.2
Use a demand and supply model to determine market interest rates for bonds.
4.3
Use the bond market model to explain changes in interest rates.
4.4
Use the loanable funds model to analyze the international capital market.

3. Are There Any Safe Investments?
Recently, interest rates on U.S. Treasury notes and corporate bonds have been falling from their historical averages.
If interest rates on those securities rose back to their historical averages, bond holders would suffer capital losses.
Many financial advisers have warned investors of this interest rate risk in holding bonds.
In this chapter, we study how investors take into account expectations of inflation and other factors when making investment decisions.

4. Key Issue and Question
Issue: Federal Reserve policies to combat the recession of 2007–2009 led some economists to predict that inflation would rise and make long-term bonds a poor investment.
Question: How do investors take into account expected inflation and other factors when making investment decisions?

5. 4.1
Learning Objective
Discuss the most important factors in building an investment portfolio.

6. How to Build an Investment Portfolio
The Determinants of Portfolio Choice
Determinants of portfolio choice (asset demand) are:
The saver’s wealth
2. The expected rates of return from different investments
3. The degrees of risk in different investments
4. The liquidity of different investments
5. The costs of acquiring information about different investments
How to Build an Investment Portfolio

7. Expected Rate of Return
Wealth
An increase in wealth generally increases the quantity demanded for most financial assets.
Expected Rate of Return
Expected return is the return expected on an asset during a future period.
The expected return on an investment is:
Expected return = [(Probability of event 1 occurring) X (Value of event 1)] + [(Probability of event 2 occurring) X (Value of event 2)].
Example: Equal probability of a rate of return of 15% and 5%.
Expected return = (0.50)(15%) + (0.50)(5%) = 10%.
How to Build an Investment Portfolio

8. Risk is the degree of uncertainty in the return on an asset.
Most investors are risk averse – choose the asset with the lower risk when two assets have the same expected returns – resulting in trade-offs between risk and return.
Risk-loving investors prefer to hold risky assets with the possibility of maximizing returns.
Risk-neutral investors make decisions on the basis of expected returns, ignoring risk.
How to Build an Investment Portfolio

9. Making the Connection
Fear the Black Swan!
Investors in stocks of small companies from 1926 to 2011 experienced the highest average returns but also accepted the most risk (measured by the standard deviation of returns).
U.S. Treasury bills had the lowest average returns but also the least risk.
Some economists see the financial crisis as a black swan – a rare event that has a large impact on the economy – which might affect the conventional measure of risk.
Teaching Tips: The authors introduce the concept of a “Black Swan” event that was developed by Nassim Taleb, professional investor and professor at New York University. The basic idea of a black swan is that, occasionally, there are “unique” events that take place (more often than people think) that have a significantly adverse effect on returns. An article titled “Preparing for the Next Black Swan” in the Wall Street Journal (August 21, 2010), points out that diversification may not be sufficient in reducing risk when there are Black Swan events. For example, during the financial crisis in late 2008, virtually all asset classes declined in value at the same time. Instead of relying on only diversification, investors may instead want to make use of various forms of derivatives to prepare for Black Swans. However, there is no free lunch, since there are costs involved in purchasing derivatives while they may only be exercised on rare occasions. This topic will be explored further in Chapter 7.
How to Build an Investment Portfolio

10. The Cost of Acquiring Information
Liquidity
The greater an asset’s liquidity, the more desirable the asset is to investors.
The Cost of Acquiring Information
All else being equal, investors will accept a lower return on an asset that has lower costs of acquiring information.
Desirable characteristics of a financial asset cause the quantity of the asset demanded by investors to increase, and vice versa.
How to Build an Investment Portfolio

11. How to Build an Investment Portfolio

12. Diversification
Diversification is dividing wealth among many different assets to reduce risk.
Market (systematic) risk is risk that is common to all assets of a certain type, e.g., changes in stock returns as a result of the business cycle.
Idiosyncratic (unsystematic) risk is risk that pertains to a particular asset (or a firm) rather than to the market as a whole.
How to Build an Investment Portfolio

13. How Much Risk Should You Tolerate in Your Portfolio?
Making the Connection
In Your Interest
How Much Risk Should You Tolerate in Your Portfolio?
Your time horizon is an important factor in deciding on the degree of risk.
Saving plans are also affected by the effects of inflation and taxes.
How to Build an Investment Portfolio

14. 4.2
Learning Objective
Use a demand and supply model to determine market interest rates for bonds.
Teaching Tips: In recent years, there has been considerable concern about the sovereign debt crisis in Europe, with particular attention paid to Greece, Portugal, and Spain. Have students discuss the response of global investors to this crisis. Be sure to indicate how global investors fled to government bonds that are perceived to be safe havens – such as those of Germany and the United States, resulting in a decline in interest rates on those bonds.

15. Market Interest Rates and the Demand and Supply for Bonds
A bond’s price (P) and its yield to maturity (i) are linked by the equation showing its coupon payments (C), face value (FV) and maturity in n years:
Because C and FV do not change, once we know P in the bond market, we have determined the equilibrium i.
The bond market approach (bonds as the good) is useful when considering how the factors affecting the demand and supply for bonds affect the interest rate.
The market for loanable funds approach (funds as the good) is useful when considering how changes in the demand and supply of funds affect the interest rate.
Market Interest Rates and the Demand and Supply for Bonds

16. A Demand and Supply Graph of the Bond Market
Figure 4.1
The Market for Bonds
The equilibrium price of bonds is determined in the bond market.
By determining the price of bonds, the bond market also determines the interest rate on bonds.
In this figure, a one-year discount bond with a face value of $1,000 has an equilibrium price of $960, which means it has an interest rate (i) of 4.2%.
The equilibrium quantity of bonds is $500 billion. The interest rate of 4.2% is calculated as follows: i = (FV – P)/P.
The demand curve represents the relationship between the price of bonds and the quantity of bonds demanded by investors. The supply curve represents the relationship between the price of bonds and the quantity of bonds supplied by investors who own existing bonds and by firms that are considering issuing new bonds.
Market Interest Rates and the Demand and Supply for Bonds

17. Equilibrium in Markets for Bonds
Figure 4.2
Equilibrium in Markets for Bonds
At $960, the quantity of bonds demanded by investors equals the quantity of bonds supplied by borrowers.
At any price higher or lower than $960, the quantity of bonds demanded is not equal to the quantity of bonds supplied.
Note: At any price above $960, there is an excess supply of bonds, and the price of bonds will fall. At any price below $960, there is an excess demand for bonds, and the price of bonds will rise. The behavior of bond buyers and sellers pushes the price of bonds to the equilibrium of $960.
The interest rate on the bond is:
Market Interest Rates and the Demand and Supply for Bonds

18. Explaining Changes in Equilibrium Interest Rates
In drawing the demand and supply curves for bonds, factors other than the prices of bonds are held constant.
If the price of bonds changes, we move along the demand (supply) curve, so we have a change in quantity demanded (supplied).
If any other relevant variable changes, then the demand (supply) curve shifts, and we have a change in demand (supply).
Market Interest Rates and the Demand and Supply for Bonds

19. Factors That Shift the Demand Curve for Bonds
Five factors cause the demand curve for bonds to shift:
1. Wealth
2. Expected return on bonds
3. Risk
4. Liquidity
5. Information costs
Market Interest Rates and the Demand and Supply for Bonds

20. Wealth Shifts in the Demand Curve for Bonds
Figure 4.3 (1 of 2)
Shifts in the Demand
Curve for Bonds
An increase in wealth will shift the demand curve for bonds to the right. As a result, both the equilibrium price of bonds and the equilibrium quantity of bonds increase.
Market Interest Rates and the Demand and Supply for Bonds

21. Wealth Shifts in the Demand Curve for Bonds (continued)
Figure 4.3 (2 of 2)
Shifts in the Demand
Curve for Bonds (continued)
A decrease in wealth will shift the demand curve for bonds to the left. As a result, both the equilibrium price and the equilibrium quantity of bonds decrease.
Market Interest Rates and the Demand and Supply for Bonds

22. Expected Return on Bonds
If the expected return on bonds rises relative to expected returns on other assets, investors will increase their demand for bonds.
Risk
A decrease in the riskiness of bonds relative to the riskiness of other assets increases the willingness of investors to buy bonds.
Liquidity
If the liquidity of bonds increases, investors demand more bonds at any given price.
Information Costs
As a result of the lower information costs, investors are more willing to buy bonds.
Teaching Tips: Ask the students how the demand curve for bonds will shift in each case.
Market Interest Rates and the Demand and Supply for Bonds

23. Factors That Shift the Demand Curve for Bonds
Table 4.2 (1 of 3)
Factors That Shift the Demand Curve for Bonds
Teaching Tips: Encourage students to spend some time reviewing this table.
Market Interest Rates and the Demand and Supply for Bonds

24. Factors That Shift the Demand Curve for Bonds
Table 4.2 (2 of 3)
Factors That Shift the Demand Curve for Bonds
Market Interest Rates and the Demand and Supply for Bonds

25. Factors That Shift the Demand Curve for Bonds
Table 4.2 (3 of 3)
Factors That Shift the Demand Curve for Bonds
Market Interest Rates and the Demand and Supply for Bonds

26. Factors That Shift the Supply Curve for Bonds
Important factors for explaining shifts in the supply curve for bonds:
1. Expected pretax profitability of physical capital investments
2. Business taxes
3. Expected inflation
4. Government borrowing
Market Interest Rates and the Demand and Supply for Bonds

27. Expected Pretax Profitability of Physical Capital Investments
Figure 4.4 (1 of 2)
Shifts in the Supply
Curve for Bonds
An increase in firms’ expectations of the profitability of investments in physical capital will shift the supply curve for bonds to the right.
As a result, the equilibrium price of bonds falls and the equilibrium quantity of bonds rises.
Market Interest Rates and the Demand and Supply for Bonds

28. Expected Pretax Profitability of Physical Capital Investments
Figure 4.4 (2 of 2)
Shifts in the Supply
Curve for Bonds (continued)
If firms become pessimistic about the profits they could earn from investing in physical capital, the supply curve for bonds will shift to the left.
As a result, the equilibrium price increases and the equilibrium quantity of bonds decreases.
Market Interest Rates and the Demand and Supply for Bonds

29. Business Taxes
When business taxes are raised, the profits on new investments in physical capital decline, and firms issue fewer bonds.
Expected Inflation
For any given nominal interest rate, an increase in the expected rate of inflation reduces the expected real interest rate.
A lower expected real interest rate is attractive for a firm as it will pay less in real terms to borrow funds.
Teaching Tips: Ask the students how the supply curve for bonds will shift in each case.
Market Interest Rates and the Demand and Supply for Bonds

30. Government Borrowing The Federal Budget, 1960-2012
Teaching Tips: A government deficit occurs with government expenditures exceed tax receipts. Ask students how a severe recession like the recession would lead to dramatic increases in federal government deficits.
Figure 4.5
The Federal Budget,
The recession of 2007–2009 led to record federal government deficits that required borrowing heavily by selling bonds.
Market Interest Rates and the Demand and Supply for Bonds

31. Why Are Bond Interest Rates So Low?
Making the Connection
Why Are Bond Interest Rates So Low?
If nothing else changes, a larger government deficit and thus borrowing shifts the bond supply curve to the right, resulting in a higher interest rate.
In 2012, bond interest rates remained low despite record deficits.
When the government runs a deficit, households may begin to increasing saving in anticipation for future tax payments to finance the deficit.
Due to increased household saving, the demand curve for bonds shifts to the right when the supply curve for bonds also shifts to the right.
As a result, the interest rate would not rise.
The Loanable Funds Model and the International Capital Market 31

32. Factors That Shift the Supply Curve for Bonds
Table 4.3 (1 of 2)
Factors That Shift the Supply Curve for Bonds
Teaching Tips: Encourage students to spend some time reviewing this table.
Market Interest Rates and the Demand and Supply for Bonds

33. Factors That Shift the Supply Curve for Bonds
Table 4.3 (2 of 2)
Factors That Shift the Supply Curve for Bonds
Market Interest Rates and the Demand and Supply for Bonds

34. 4.3
Learning Objective
Use the bond market model to explain changes in interest rates.

35. The Bond Market Model and Changes in Interest Rates
Examples of using the bond market model to explain changes in interest rates:
(1) The movement of interest rates over the business cycle.
(2) The Fisher effect, which is the movement of interest rates in response to changes in the inflation rate.
The Bond Market Model and Changes in Interest Rates

36. Why Do Interest Rates Fall During Recessions?
Figure 4.6
Interest Rate Changes in an Economic Downturn
An economic downturn reduces household wealth and thus decreases the demand for bonds.
The fall in expected profitability reduces lenders’ supply of bonds.
In the new equilibrium (E2), the bond price rises.
The Bond Market Model and Changes in Interest Rates

37. How Do Changes in Expected Inflation Affect Interest Rates?
The Fisher Effect
The Fisher effect (asserted by Irving Fisher) indicates that the nominal interest rate changes point-for-point with changes in the expected inflation rate.
The Fisher effect implies that:
1. Higher inflation rates result in higher nominal interest rates, and vice versa.
2. Changes in expected inflation can lead to changes in nominal interest rates before a change in actual inflation occurrs.
The Bond Market Model and Changes in Interest Rates

38. Expected Inflation and Interest Rates
Figure 4.7
Expected Inflation and Interest Rates
An increase in expected inflation reduces investors’ expected real return, thus the demand curve for bonds shifts to the left.
The increase in expected inflation increases firms’ willingness to issue bonds, thus the supply curve for bonds shifts to the right.
In the new equilibrium (E2), the bond price falls.
The Bond Market Model and Changes in Interest Rates

39. Solved Problem 4.3
In Your Interest
Should You Worry About Falling Bond Prices When the Inflation Rate Is Low?
The inflation rate in late 2012 was about 2%. In the Wall Street Journal, a columnist wrote: “Someone buying long-term bonds yielding 1.5% or 2%, and then seeing consumer price inflation of 4%, will be on the losing end of the bet.”
a. Explain what will happen to the price of bonds if the expected inflation rate increases to 4% from 2%. Include a demand and supply graph of the bond market.
b. Suppose that you expect a greater increase in inflation than do other investors, but that you don’t expect the increase to occur until Should you wait until 2015 to sell your bonds? Briefly explain.
The Bond Market Model and Changes in Interest Rates

40. In Your Interest (continued)
Solved Problem 4.3
In Your Interest (continued)
Should You Worry About Falling Bond Prices When the Inflation Rate Is Low?
c. The columnist also argued that long-term bonds would be a good investment only if “we get serious price deflation.” Explain the effect on bond prices if investors decide that price deflation is likely to occur. How would an unexpected deflation affect the rate of return on your investment in bonds?
d. If expected inflation is increasing, would you have made a worse investment if you had invested in long-term bonds than if you had invested in short-term bonds?
The Bond Market Model and Changes in Interest Rates 40

41. Solved Problem 4.3
In Your Interest
Should You Worry About Falling Bond Prices When the Inflation Rate Is Low?
Solving the Problem
Step 1 Review the chapter material.
Step 2 Answer part (a) by explaining why an increase in expected inflation may make bonds a bad investment and illustrate your response with a graph.
The Bond Market Model and Changes in Interest Rates

42. Solved Problem 4.3
In Your Interest
Should You Worry About Falling Bond Prices When the Inflation Rate Is Low?
Solving the Problem (continued)
Step 3 Answer part (b) by discussing the difference in the effects of actual and expected inflation on changes in bond prices.
Changes in bond prices result from changes in the expected rate of inflation. If buyers and sellers change their expectations, the nominal interest rate will adjust. Waiting until the nominal interest rate had risen would be too late to avoid the capital losses from owning bonds.
Step 4 Answer part (c) by explaining the effect on the bond market of unexpected deflation.
For example, if buyers and sellers of bonds are willing to accept an expected real interest rate of 3%, then if the expected inflation rate is 1%, the nominal interest rate will be 4%.
An unexpected deflation will shift the demand curve for bonds to the right and the supply curve to the left. The price of bonds will increase as a result, so a bond investor will experience a higher rate of return or capital gain.
The Bond Market Model and Changes in Interest Rates 42

43. In Your Interest (continued)
Solved Problem 4.3
In Your Interest (continued)
Why Worry About Falling Bond Prices When the Inflation Rate Is Low?
Solving the Problem (continued)
Step 5 Answer part (d) by explaining why long-term bonds are a particularly bad investment if expected inflation increases.
An increase in expected inflation will increase the nominal interest rate on all bonds, but the increases will be more on bonds with a longer maturity. So, the capital losses on long-term bonds will be greater than on short-term bonds.
For example, if buyers and sellers of bonds are willing to accept an expected real interest rate of 3%, then if the expected inflation rate is 1%, the nominal interest rate will be 4%.
The Bond Market Model and Changes in Interest Rates
[To Jim: should notes below appear on both slides 43 & 44?]

44. 4.4
Learning Objective
Use the loanable funds model to analyze the international capital market.
Teaching Tips: For years, the United States has experienced huge net capital inflows. Some people are concerned about borrowing from abroad. Have students discuss what would happen to real interest rates in the United States if the United States restricted borrowing from overseas (i.e., if the United States became a more closed economy).

45. The Loanable Funds Model and the International Capital Market
A borrower is the buyer of loanable funds and a lender is the seller.
When looking at the flow of funds between the U.S. and foreign financial markets, the loanable funds approach is more useful than the demand and supply of bonds approach.
The Loanable Funds Model and the International Capital Market

46. The Demand and Supply of Loanable Funds
Figure 4.8
The Demand for Bonds and the Supply of Loanable Funds
In panel (a), the bond demand curve (Bd) shows a negative relationship between the quantity of bonds demanded by lenders and the price of bonds.
In panel (b), the supply curve for loanable funds (Ls) shows a positive relationship between the quantity of loanable funds supplied by lenders and the interest rate.
The Loanable Funds Model and the International Capital Market

47. The Demand and Supply of Loanable Funds
Figure 4.9
The Supply of Bonds and the Demand for Loanable Funds
In panel (a), the bond supply curve (Bs) shows a positive relationship between the quantity of bonds supplied by borrowers and the price of bonds.
In panel (b), the demand curve for loanable funds (Ld) shows a negative relationship between the quantity of loanable funds demanded by borrowers and the interest rate.
The Loanable Funds Model and the International Capital Market

48. Equilibrium in the Bond Market from the Loanable Funds Perspective
Figure 4.10
Equilibrium in the Market for Loanable Funds
At the equilibrium interest rate, the quantity of loanable funds supplied by lenders equals the quantity of loanable funds demanded by borrowers.
The Loanable Funds Model and the International Capital Market

49. The International Capital Market and the Interest Rate
The foreign sector influences the domestic interest rate and the quantity of funds available in the domestic economy.
The loanable funds approach provides a good framework for analyzing the interaction between U.S. and foreign bond markets.
In a closed economy, households, firms, and governments do not borrow or lend internationally.
In an open economy, households, firms, and governments borrow and lend internationally.
The Loanable Funds Model and the International Capital Market

50. Small Open Economy
In a small open economy, the quantity of loanable funds supplied or demanded is too small to affect the world real interest rate.
Key Features:
The real interest rate in a small open economy is the same as the interest rate in the international capital market.
If the quantity of loanable funds supplied domestically exceeds the quantity of funds demanded domestically, the country invests some of its loanable funds abroad.
If the quantity of loanable funds demanded domestically exceeds the quantity of funds supplied domestically, the country finances some of its domestic borrowing needs with funds from abroad.
The Loanable Funds Model and the International Capital Market

51. Small Open Economy
Figure 4.11
Determining the Real Interest Rate in a Small Open Economy
The domestic real interest rate in a small open economy is the world real interest rate (rw), which is 3% in this case.
The Loanable Funds Model and the International Capital Market

52. Large Open Economy
In a large open economy, changes in the demand and supply for loanable funds are large enough to affect the world real interest rate.
In this case, we cannot assume that the domestic real interest rate is equal to the world real interest rate.
The Loanable Funds Model and the International Capital Market

53. Determining the Real Interest Rate in a Large Open Economy
Teaching Tip: Ask the students what happens to the United States and the rest of the world when the world interest rate is 3% instead of 4%.
Figure 4.12
Determining the Real Interest Rate in a Large Open Economy
The world real interest rate adjusts to equalize desired international borrowing and desired international lending.
The Loanable Funds Model and the International Capital Market

54. Did a Global “Saving Glut” Cause the U.S. Housing Boom?
Making the Connection
Did a Global “Saving Glut” Cause the U.S. Housing Boom?
In response to the argument that the Fed’s low-interest-rate policy in the 2000s fueled the housing boom, Ben Bernanke argued that “a significant increase in the global supply of saving—a global saving glut helps to explain the relatively low level of long-term interest rates in the world today.”
Note: Bernanke’s argument is explained in the figure using the loanable funds model for a large open economy. The world real interest rate is 3%. At that interest rate, the U.S. is borrowing $200 billion from aboard, and the rest of the world is lending $200 billion.
The Loanable Funds Model and the International Capital Market

55. Answering the Key Question
At the beginning of this chapter, we asked the question:
“How do investors take into account expected inflation and other factors when making investment decisions?”
Investors change their demand for bonds as a result of changes in a number of factors.
When expected inflation increases, the real interest rate decreases and thus investors reduce their demand for bonds for each nominal interest rate.
Increases in expected inflation also lead to higher nominal interest rates and capital losses for investors who hold bonds.