Interest Rate Fluctuations Chapters 5 1

Learning Objectives • Understand why bond prices and interest rates move in the opposite direction • Describe the structure of TIPS • Use supply and demand analysis to explain the effect of various events on the interest rate • Use supply and demand analysis to explain the Fisher effect.

2

Relationship Between Price and Yield to Maturity

.

3

TIPS (Treasury Inflation Protection Securities) • Originally issued in 1997.

• Interest and principal payments are adjusted for inflation.

• In times of high inflation the $ amount paid to investors rises.

• Return on TIPS relative to regular Treasurys provides information on expected inflation.

4

Yields on 1-month T-bills 2001-2008 5

“The” Interest Rate: averaging across risk and maturity 6

“The” Interest Rate: averaging across

risk

and maturity 7

“The” Interest Rate: averaging across risk and

maturity

8

Economists can’t predict … … but they can explain after the fact.

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Supply and Demand of Bonds Supply: borrowers (issuers of bonds) Demand: lenders (buyers of bonds) 10

Price (PV)

750 800 850 900 950 N=1, FV=1000

Yield (I/Y)

11

Price (PV)

750 800 850 900 950 N=1, FV=1000

Yield (I/Y)

33.33

25.00

17.65

11.11

5.26

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Supply and Demand Analysis of the Bond Market 13

Movement along the curve Versus Shifts of the curve 14

Shift Factors for the Demand for Bonds • Wealth • Expected return • Expected interest rate • Inflationary expections • Relative Risk • Relative Liquidity 15

Shifts in the Bond Demand Curve 16

Shift Factors for Supply of Bonds

1.

Profitability of Investment Opportunities

Business cycle expansion, investment opportunities  ,

B s B s

shifts out to right  ,

2.Expected Inflation



e

 ,

B s

 ,

B s

shifts out to right

3.Government Activities

Deficits  ,

B s

 ,

B s

shifts out to right 17

Shifts in the Bond Supply Curve 18

Changes in 

e

: the Fisher Effect If 

e

1.

B d

 shifts in to 2.

3.

left

B s

 ,

B s

shifts out to right

P

 ,

i

 © 2005 Pearson Education Canada Inc.

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• What will happen to bond prices if stock trading commissions decrease? Why? • What will happen to bond prices if bond trading commissions increase? Why? • What will happen to bond prices if the government implements tax increases? Why? 20

• If government revenues drop significantly (and remember all else stays the same, including government expenditures), what will likely happen to bond prices? Why? • If the government guaranteed the payment of bonds, what would happen to their prices? Why? • What will happen to bond prices if the government implements regulatory reforms that reduce regulatory costs for businesses? Why? 21

• If government revenues increase significantly, what will likely happen to bond prices? Why? • What will happen to bond prices if terrorism ended and the world’s nations unilaterally disarmed and adopted free trade policies? Why? • What will happen to bond prices if world peace brought substantially lower government budget deficits? 22

Changes in the money supply Two effects: The initial effect of more money to invest lowers the interest rate, but if market participants expect inflation then the Fisher effect will cause the interest rate to increase.

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