FIN 515: Financial Markets & Institutions - Ch. 4 Q&As

In the aftermath of the global financial crisis, US government budget deficits increased dramatically, yet interest rates on US Treasury debt fell sharply and stayed low for many years. Does this make sense? Why or why not?

11. Yes. The increase in budget deficits increased the supply of bonds and shifts the supply curve B5 to the right, which everything else equal would decrease bond prices and raise interest rates. However, the weak economy in the aftermath of the global financial crisis caused investment opportunities to shrink so dramatically that it shifted the supply curve B5 to the left by more than the deficits shifted it to the right. The result was that the price of Treasury bonds rose and interest rates on these bonds fell.

You own a 1000 par zero coupon bond that has five years of remaining maturity. You plan on selling the the bond in one year and believe that the interest rate next year will have the following probability distribution. A. What is your expected price when you sell the bond? B. What is the standard deviation of the bond price?

A. The expected price is $763.07. B. The variance is $46.09, or a standard deviation of $6.79.

Suppose Great Britain leaves the Eurozone, causing a recession in Europe. Considering the Eurozone is big commercial partner of the United States, how do you think this might affect the bond market in the United States? Is the effect on the US interest rate ambiguous or not?

If a big commercial partner of the US enters into a recession, this will probably adversely affect the business of many US companies that export goods and services to that country or region (the Eurozone in this case). This will most likely result in job losses and a decrease in wealth, at the same time that there will be a decrease in investment opportunities. The first effect will shift the demand for bonds curve to the left, while the latter will shift the supply curve of bonds to the left. The result is that the equilibrium quantity of bonds issued and bought will unambiguously decrease, while the effect on bond's prices and the interest rate will appear to be ambiguous. However, this might not be very different from a domestic recession, so one can expect interest rates to decrease.

Suppose that many big corporations decide not to issue bonds, since it is now too costly to comply with new financial market regulations. Can you describe the expected effect on interest rates?

If many big corporations decide not to issue bonds because of new financial markets regulations, this will affect the supply curve. The impact will translate into a shift to the left in the supply curve, increasing bond's prices (lowering interest rates) and lowering the quantity of bonds bought and sold in the market.

Suppose that people in France decide to permanently increase their savings rate. Predict what will happen to the French bond market in the future. Can France expect higher or lower domestic interest rates?

If people in France decide to permanently increase their savings rate, then more wealth will be accumulated over the years. This increase in wealth determines that more bonds will be bought at any given interest rate (or bond's price), creating a shift to the right in the demand curve for bonds in France. This European country can therefore expect permanent lower interest rates in the future.

What will happen in the bond market if the government imposes a limit on the amount of daily transactions? Which characteristic of an asset would be affected?

If the government imposes a limit on the amount of daily transactions in the bond market, then bonds will become less liquid with respect to alternative assets. Such a regulation will mean that it will now be more difficult to find buyers and sellers in the bond market, thereby affecting the liquidity of bonds and the demand curve (which will shift to the left), increasing the interest rate and lowering bond's prices (for a given supply curve).

Suppose you are in charge of the financial department of your company and you have to decide whether to borrow short- or long-term. Checking the news, you realize that the government is about to engage in a major infrastructure plain in the near future. Predict what will happen to interest rates. Will you advise borrowing short- or long-term?

If the government is planning to fund a major infrastructure plan, it will need to get funds, and thereby will probably issue more bonds. Since the government is a major player in the market for bonds, this will most likely result in a shift to the right in the supply curve, lowering the price of bonds and increasing interest rates in the future. If you have the opportunity, it would be wise to lock in now a long term loan with current low interest rates.

How might a sudden increase in people's expectations of future real estate prices affect interest rates?

Interest rates would rise. A sudden increase in people's expectations of future real estate prices raises the expected return on real estate relative to bonds, so the demand for bonds falls. The demand curve Bd shifts to the left, and the equilibrium bond price falls, so the interest rate rises.

Suppose Maria prefers to buy a bond with a 7% expected return and 2% standard deviation of its expected return, while Jennifer prefers to buy a bond with a 4% expected return and a 1% standard deviation of its expected return. Can you tell if Maria is more or less risk-averse than Jennifer?

Maria is choosing a bond with higher standard deviation, but also with higher expected return than Jennifer. In order to decide whether Maria or Jennifer is more risk averse, one will need to compare two bonds with the same expected return and different standard deviations of their expected returns. Since a high expected return is a desirable characteristic of a bond and a high volatility of its expected return (high standard deviation) is a non-desirable characteristic, it is not uncommon that highly volatile bonds exhibit higher expected returns, as the bond preferred by Maria.

I own a professional football team, and I plan to diversify by purchasing shares in either a company that owns a pro basketball team or a pharmaceutical company. Which of these two investments is more likely to reduce the overall risk I face? Why?

Purchasing shares in the pharmaceutical company is more likely to reduce my overall risk because the correlation of returns on my investment in a football team with the returns on the pharmaceutical company shares should be low. By contrast, the correlation of returns on an investment in a football team and an investment in a basketball team are probably pretty high, so in this case there would be little risk reduction if I invested in both.

Raphael observes that at the current level of interest rates there is an excess supply of bonds, and therefore he anticipates an increase in the price of bond. Is Raphael correct?

Raphael is incorrect. If at the current level of interest rates there is an excess supply of bonds, the supply and demand analysis tells us that interest rates will increase, creating a movement along both the demand curve (in the southeast direction) and the supply curve (in the southwest direction) in order to reach the equilibrium interest rate (and price). The bond's price will therefore fall and the interest rate will rise to the equilibrium level.

The Chairman of the Fed announces that interest rates will rise sharply next year, and the market believes him. What will happen to today's interest rate on the AT&T bonds, such as 8 1/8s of 2022?

The interest rate on the AT&T bonds will rise. Because people now expect interest rates to rise, the expected return on long-term bonds such as the s.1s of 2022 will fall, and the demand for these bonds will decline. The demand curve BJ will therefore shift to the left, and the equilibrium bond price falls and the interest rate will rise.

How would the demand curve for corporate bonds be affected if news about accounting scandals in major corporations spread? What would be the effect on interest rates?

When news about accounting scandals in big corporations spread, people get worried about the quality of the bonds they are either holding or considering to buy. We can expect then that bonds are not as desirable assets as they were before (maybe because the ability of corporations to honor their commitments was overstated). This negatively affects demand for these bonds and shifts the demand curve to the left, raising interest rates and lowering corporate bond's prices (for a given supply curve).

An important way in which the Federal Reserve decreases the money supply is by selling bonds to the public. Using a supply-and-demand analysis for bonds, show what effect this action has on interest rates.

When the Fed sells bonds to the public, it increases the supply of bonds, thus shifting the supply curve as to the right. The result is that the intersection of the supply and demand curves as and ad occurs at a lower equilibrium bond price and thus a higher equilibrium interest rate, and the interest rate rises.

Using supply-and-demand for bonds framework, show why interest rates are pro-cyclical (rising when the economy is expanding and falling during recessions).

When the economy booms, the demand for bonds increases: The public's income and wealth rises while the supply of bonds also increases, because firms have more attractive investment opportunities. Both the supply and demand curves (ad and as) shift to the right, but as is indicated in the text, the demand curve probably shifts less than the supply curve so the equilibrium interest rate rises. Similarly, when the economy enters a recession, both the supply and demand curves shift to the left, but the demand curve shifts less than the supply curve so that the bond price rises and the interest rate falls. The conclusion is that bond prices fall and interest rates rise during booms and fall during recessions, that is, interest rates are procyclical.

will there be an effect on interest rates if brokerage commissions on stocks​ fall? Explain your answer.

Yes, interest rates will rise. The lower commission on stocks makes them more liquid than bonds, and the demand for bonds will fall. The demand curve Bd will therefore shift to the left, and the equilibrium bond price falls and the interest rate will rise.

Explain why you would be more or less willing to buy a share of Verizon stock in the following situations: A. Your wealth fails B. You it (Verizon stock) to appreciate in value C. The bond market becomes more liquid D. You expect gold to appreciate in value E. Prices in the bond market become more volatile

a. Less, because your wealth has declined b. More, because its relative expected return has risen c. Less, because it has become less liquid relative to bonds d. Less, because its expected return has fallen relative to gold e. More, because it has become less risky relative to bonds

Explain why you would be more willing or less willing to buy a house under the following circumstances: a. You just inherited $100,000 b. Real estate commissions fall from 6% of the sales price to 4% of the sales price c. You expect Verizon stock to double in value next year d. Price in the stock market become more volatile e. You expect housing prices to fall

a. More, because your wealth has increased b. More, because it has become more liquid c. Less, because its expected return has fallen relative to Polaroid stock d. More, because it has become less risky relative to stocks e. Less, because its expected return has fallen