Question

Prior to beginning work on this assignment, read Hubbard and O’Brien’s (2017) Chapters 3 and 4. Choice Financial is a financial services firm based in San Diego, California. In early 2018, Tom Jones, a financial analyst for the firm, predicted that the inflation rate would go up from 1.5% in 2018 to 6% in 2020. He advised investors not to buy bonds because their prices would fall as inflation increased.

Explain why bond prices fall when inflation increases.
Analyze the relationship between the price of bonds and interest rates.
Appraise how interest rates are determined using the following models and whether the different models produce different results in determination of interest rates:
Demand and Supply
Bond Market
Money Market
Evaluate how each of the following affects interest rates and the price of bonds:
Yield to Maturity
Bond Yields
Risk

Answer 1

Bond prices fall when inflation increases because of two reasons which are as follows:

i) If inflation rate becomes higher than the coupon rate (coupon rate is the rate at which periodic interest payments are made to the bond holders); the purchasing power of each coupon payment decreases i.e. it becomes unattratctive to the potential investors which in-turn reduces the demand for the bond.

ii) When inflation rate increases or is expected to increase; the central bank of the country in order to control inflation hikes the interest rate (borrowing money becomes expensive) which makes the other interest rates and bond yields to go up as well. Existing bonds paying lower interest rates become less valuable (and therefore less in demand) than their newer counterparts giving higher interest rates. Since, demand and price follow an inverse relationship therefore prices of bond falls when inflation increases.

Price of bond and Interest rate share an inverse relationship i.e. when price of bond increases then interest rate falls and vice versa.

Yield to Maturity (YTM) also known as the Redemption Yield is the market discount rate used for discounting a bond's cash flows. Bond's YTM can be used to calculate the price of the bond. When bond yields increases, the present value of a bond i.e. its market value decreases and when the bond yields decreases, the market value of a bond increases. Bond yield and prices are said to share a convex relationship and this effect is known as convexity.

Note: Bond YTM and bond yield are often used interchangeably.

Risks associated with a bond has a direct relationship with interest rates. Bonds with higher risk will have higher interest rate (YTM) as compared to the bonds with lower risk in order to compensate for the additional risk taken. Higher interest rate would mean lower prices for a bond i.e. selling at a discount while lower interest rate would mean higher prices for a bond i.e. selling at a premium.   

Determination of interest rates using different models falls under the Economics curriculum.