Question

2. Bond prices and interest rates Aa Aa The remarkable thing about the events described in the article is that the yield on the 3-month T-bill was briefly negative. To see how this could happen, you need an understanding of the relationship between bond prices and bond yields A 3-month T-bill with a maturity value of $1,000 is just a piece of paper that entitles the holder to $1,000 in three months. For example, if you were to buy a 3-month T-bl on September 24, 2008 with a maturity value of $1,000 and 90 days left to maturity, the U.S. government would pay you $1,000, on December 23, 2008 In general, the price of a bond is less than its maturity value. That is, if you are going to give up a certain amount of money for the duration of the bond, you expect to be paid for this loss of liquidity, and also to be compensated for inflation that could reduce the value of the repayment at the end of the period. Therefore, a piece of paper entitling you to $1,000 on December 23 would usually be worth less than $1,000 on September 24. The yield on a bond is a function of the percent by which your money implicitly grows while invested in it. In order to compare yields among bonds, yield is always reported as an annual interest rate. A bond's yield is a function of its maturity value (M), its price (PB), and the number of days until it matures. The general formula for the yield on a zero-coupon bond such as a T-bill is: M - Pe 360 Percentage Yield -100% x- Days to Maturity For example, if you were to pay $995 for a T-bill maturing in 90 days with a face value of $1,000, the percentage yield would be: $1,000 $995 $1,000 $5 $1,000 360 Percentage Yield -10096 x 100% x 0.005 2% Use this method to calculate yields on 3-month T-bills for each of the prices in the table below. Enter your results in the right column of the table, rounded to the nearest percent. Assume that all the T-bills have a maturity value (M) of $1,000 Price of a 3-Month T-Bill with 90 Days Left to Maturity (PB) $1,002.50 $1,000.00 $995.00 $992.50 $987.50 Yield (Percent) Based on the data from your table above, use the black points (X symbol) to plot the relationship between T-bill prices and their yields on the graph below. Be sure to plot from left to right. Line segments will automatically connect the points YIELD ON 3-MONTH T-BILL (Percent) T-Bill Price/Yield 985 990 995 1000 1005 PRICE OF 3-MONTH T-BILLDasHlp Clear All Look back at the points you plotted. The line showing the relationship between bond prices and bond yields has a slope; hence, there is relation between bond prices and interest rates You can see from the data that the implied yield on a bond becomes negative when its price maturity value. Which of the following events would most likely lead to such a situation in the T-bill market? O The United States Treasury Department holds a large auction of T-bills, increasing the supply of T-bills in the market. A massive decrease in investor confidence sharply increases the demand for T-bills. The increased demand causes T-bill prices to rise above their maturity values O The United States government is forced to shut down its offices for several months because Congress and the President cannot pass a budget

Answer 1

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