Bond markets (from lowest to highest risk):
- federal bonds ---> risk -free asset
- municipal gov. bonds
- corporate bonds
investment grade
"junk bonds" --> high-risk
risk v. return
The Bond Market
- we will assume only simplest form of a bond
"zero-coupon" bond
- FV = face value = amount borrower must pay on the maturity date
- maturity date: date when bond comes due
- Fed. govt. promises to pay $10,000 on July 1, 2017
- Generally, zero-coupon bonds sell for a price below face value
Suppose: FV = $1,000
price = $950
Interest rate: FV - price x 100%
price
Int. rate = 1000 - 950 x 100% = 5.3%
950
Find an interest rate on a bond:
FV = 6000
price = $5,520
i = 8.7%
(see notes A)
***For a given FV, the lower the price, the higher the interest rate.
Inverse relationship. Mathematical certainty.
(see notes B)
If a price of a bond falls, the demand for the quantity of bonds increases.
(see notes C)
If a price of a bond falls, the quantity of bonds supplied decreases.
(see notes D)
equilibrium Pb and Qb.
If there is an increase in borrowing, there would be an increase in supply of quantity of bonds. Pb falls, IR increases.
(see notes E)
Investment. Investment is sensitive to interest rates.
At high interest rates, investment is low.
At low interests rates, investment is high.
(see notes F)
3 diagrams
inc. in demand for bonds =
results: price of bonds rises
IR falls
AD shifts to the right (increases)
The Money Market
Theory of Liquidity
Preference (Keynes)
How do households decide how much of their assets to hold as money v. bonds?
Money
convenient/liquid
no interest
Bonds
not as liquid or convenient
pay interest
