Question

8-1 What is the relationship between….

a) bond prices and yields?

b) bond prices and interest rates?

c) why are bond prices important to many financial institutions?

8-2 Is the price of a long term bond or the price of a short term security more sensitive to a change in interest rates? Why?

8-3 Why does the required rate of return for a particular bond change over time?

8-4 Assume that inflation is expected to decline in the near future. How could this affect future bond prices? Would you recommend that financial institutions increase or decrease their concentration of long term bonds based on this expectation?  Why?

8-5 Assume that oil-producing countries have agreed to reduce their production by 30% (not including the U.S.) How would bond prices in the U.S. be affected by this announcement? Explain.

Answer 1

Answer 8-1:

a. There is negative relatioshio between bond prices and yield. As price of the bons increases, the yield on the bond decreases and as the price of the bond decreases, the yield on the bond increases.

b.There is negative relationship between bond prices and interest rates. As rate of interest increases, bond prices decreases and as rate of interest increases, bond prices will decrease.

c. The bond prices play an important role in determining rate of interest or the cost of borrowing and lending in the economy and thus are important for financial institutions.

Answer 8-2:

The price of a long term bond is more sensitive to the changes in the rate of interest than short term binds because long term bonds have a greater duration than short term bonds that are close to maturity and thus the amount of coupon payments are also less.

ANswer 8-3

The prices of bond react to the changes in bond demand and bond supply which in turn depends on may economic activities like phase of the business cycle, expected profitability, inflation expectations, government budget balance etc. These changes in the economy leads to change in bond demand and supply which leads to changes in the price of the bond.

Answer 8-4:

If it is expcted that inflation will decline in the near future, then demand for bonds will increase and supply of bonds will decrease in the near future, this will lead to increase in the level of bond prices in the near future and decrease bond yields. Since bond yields have decreased, it is expected that financial institutions will decrease their concentration of bonds in the near future.

Answer 8-5:

A reduction in production will also reduce supply of bonds by the firms to finanace their production and as the supply of bonds gets decreased, the bond prices will increase in the bond market.