1. THE BOND MARKET Frederick University 2014

2. The Bond Market Bond supply Bond demand Bond market equilibrium

3. Bond supply bond issuers/ borrowers look at Q s as a function of price, yield

4. Bond supply lower bond prices higher bond yields more expensive to borrow lower Qs of bonds so bond supply slopes up with price

5. Bond price Q of bonds S

6. Bond Demand bond buyers/ lenders/ savers look at Q d as a function of bond price/yield

7. Bond yield Qd of bonds price of bond Qd of bonds bond demand slopes down with respect to price

8. Bond price Quantity of bonds D

9. Changes in bond price/yield Move along the bond demand curve What shifts bond demand?

10. Wealth Higher wealth increases asset demand Bond demand increases Bond demand shifts right

11. P QdQd D D

12. a change in expected inflation rising inflation decreases real return inflation expected to demand for bonds (shift left)

13. a change in exp. interest rates rising interest rates decrease value of existing bonds int. rates expected to demand for bonds (shift left)

14. a change in the risk of bonds relative to other assets relative risk of bonds demand for bonds (shift left)

15. a change in liquidity of bonds relative to other assets relative liquidity of bonds demand for bonds (shift rt.)

16. Bond supply Changes in bond price/yield Move along the bond supply curve What shifts bond supply?

17. Shifts in bond supply Change in government borrowing Increase in government borrowing Increase in bond supply Bond supply shifts right

18. P Qs S S’

19. a change in business conditions affects incentives to expand production exp. profits supply of bonds (shift rt.) exp. economic expansion shifts bond supply rt.

20. a change in expected inflation rising inflation decreases real cost of borrowing exp. inflation supply of bonds (shift rt.)

21. Bond market equilibrium changes when bond demand shifts, and/or bond supply shifts shifts cause bond prices AND interest rates to change

22. Example 1: the Fisher effect expected inflation 3%

23. exp. inflation rises to 4% bond demand -- real return declines -- Bd decreases bond supply -- real cost of borrowing declines -- Bs increases

24. bond price falls interest rate rises

25. Fisher effect expected inflation rises, nominal interest rates rise

26. Example 2: economic slowdown

27. bond demand decline in income, wealth Bd decreases P falls, i rises bond supply decline in exp. profits Bs decreases P rises, i falls

28. shift Bs > shift in Bd interest rate falls shift Bs > shift in Bd interest rate falls

29. Why shift Bs > shift Bd? changes in wealth are small response to change in exp. profits is large large cyclical swings in investment

30. Why are bonds risky? 3 sources of risk Default Inflation Interest rate

31. Default risk Risk that the issuer fails to make promised payments on time Zero for government debt Other issuers: corporate, municipal, foreign have some default risk Greater default risk means a greater yield

32. Inflation risk Most bonds promise fixed interest payments Inflation erodes the real value of these payments Future inflation is unknown Larger for longer term bonds

33. Interest rate risk Changing interest rates change the value (price) of a bond in the opposite direction. All bonds have interest rate risk But it is larger for the long term bonds