FINC 3345 Chapter 8

The ECB expects that a government with debt repayment problems will reduce its budget deficit so that it does not need to borrow so much money in the future.

Describe the conditions imposed by the European Central Bank (ECB) when it provides credit to European country governments with debt repayment problems.

Higher oil prices, excessive money supply growth, and strong economic growth contribute to higher inflationary expectations. Thus, interest rates would be expected to increase under these conditions (holding other factors constant), the demand for bonds would decline and bond prices would decline

Explain how bond prices may be affected by money supply growth, oil prices, and economic growth

The risk-free rate declined, which placed upward pressure on bond prices. The credit risk premium increased, which placed downward pressure on bond prices.

Explain how the prices of bonds were affected by a change in the risk-free rate during the credit crisis. Explain how bond prices were affected by a change in the credit risk premium during the credit crisis.

Bond price elasticity measures the percentage change in a bond's price in response to a percentage change in interest rates. The percentage change in the price (as measured by present value) of the zero-coupon bonds would be more sensitive to interest rate movements than the high-coupon bonds. Thus, a mutual fund containing zero-coupon bonds would likely have a more volatile market value over time.

Explain the concept of bond price elasticity. Would bond price elasticity suggest a higher price sensitivity for zero-coupon bonds or high-coupon bonds that are offering the same yield to maturity? Why? What does this suggest about the market value volatility of mutual funds containing zero-coupon Treasury bonds versus high-coupon Treasury bonds?

An investor's required rate of return should increase; The present value of existing bonds should decrease; The prices of existing bonds should decrease

Explain the impact of an increase in interest rates on:

Economic conditions in Europe are connected among countries

Explain why economic growth in some European countries can lead to a better economic situation in other European countries.

A European country with debt repayment problems is restricted from implementing a very expansionary fiscal policy, because this type of policy would require more financing.

Explain why fiscal policy is not normally effective in stimulating the economy of a European country that is experiencing debt repayment problems

Monetary policy in the eurozone serves several countries that use the euro as their home currency

Explain why monetary policy is not normally effective in stimulating the economy of a European country that is experiencing debt repayment problems.

The market value of the financial institution's bond portfolio will decrease. A financial institution that has a greater concentration of bonds would be more adversely affected because the market value of its portfolio would be more sensitive to interest rates

How would a financial institution with a large bond portfolio be affected by rising interest rates? Would it be affected more than a financial institution with a greater concentration of bonds (and fewer short-term securities)? Explain.

The market value of the financial institution's bond portfolio will decrease. A financial institution that has a greater concentration of bonds would be more adversely affected because the market value of its portfolio would be more sensitive to interest rates.

How would a financial institution with a large bond portfolio be affected by rising interest rates? Would it be affected more than a financial institution with a greater concentration of bonds (and fewer short-term securities)? Explain.

The price of the bond would be above its part value, because the coupons provide more than the return required

If a bond's coupon rate is above the investor's required rate of return on the bond, would the bond's price be above or below its par value? Explain.

decrease; increase

If analysts expect that the demand for loanable funds will decrease and the supply of loanable funds will increase, they would most likely expect interest rates to ____ and prices of existing bonds to ____

increase; increase

If bond portfolio managers expect interest rates to decrease in the future, they would likely ____ their holdings of bonds now, which could cause the prices of bonds to ____ as a result of their actions.

You should expect that bond prices will increase in the future, and therefore you would recommend that investors purchase bonds today.

If you expect that interest rates will fall, would you recommend that investors purchase bonds today? Explain.

The price of a long-term bond is more sensitive to a change in interest rates than the price of a short-term security. The long-term bond provides fixed payments for a longer period of time. Consequently, it will provide these fixed payments, whether interest rates decline or rise. The benefit of fixed payments during a period of falling interest rates is more pronounced for longer maturities. The same is true for the disadvantage of fixed payments during a period of rising rates.

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?

Yes because the market values of bonds or mortgages that provide fixed payments over time are very sensitive to interest rate movements.

Is the relationship between interest rates and bond prices important to financial institutions?

systemic risk.

Many financial institutions rely heavily on debt to fund their operations, and they are interconnected by virtue of financing each other's debt positions. Therefore, if one institution cannot pay its debts, it may create cash flow problems for several other institutions. The risk created by this situation is known as

This is because interest rates have increased

Prices of existing bonds have decreased. Explain the reason for it.

Interest Rate Risk

Risk that an asset will decline in value in response to interest rate movements.

Bond price elasticity

Sensitivity of bond prices to changes in the required rate of return.

A financial institution with a large portfolio of fixed-rate mortgages is favourably affected by falling interest rates, because the market value of its mortgage portfolio is increased

Since fixed-rate mortgages and bonds have similar payment flows, how is a financial institution with a large portfolio of fixed-rate mortgages affected by falling interest rates? Explain.

If the Fed's actions reduce interest rates, they may increase economic growth, which could reduce the uncertainty surrounding the economy, and lower the risk premium on corporate bonds.

The Fed's open market operations can change the money supply, which can affect the risk-free rate offered on bonds. Why might the Fed's policy also affect the risk premium on corporate bonds?

Required rate of return; coupon rate; discount

The larger the investor's ____ relative to the ____, the larger the ____ of a bond with a particular par value.

The German interest rates could have declined while U.S. interest rates increased, so that the value of the German bonds was higher than the value of U.S. bonds after five years. Even if interest rates in both countries moved in the same direction, the German bonds could have generated a higher yield. If both interest rates increased, the U.S. interest rates could have increased to a higher degree. If both interest rates decreased, the U.S. interest rates could have decreased by a smaller degree.

The pension fund manager of Utterback (a U.S. firm) purchased German 20-year Treasury bonds instead of U.S. 20-year Treasury bonds. The coupon rate was 2 percent lower on the German bonds. Assume that the manager sold the bonds after five years. The yield over the five-year period was substantially more than the yield it would have received on the U.S. bonds over the same five-year period. Explain how the German bonds could have generated a higher yield than the U.S. bonds for the manager, even if the exchange rate is stable over this five-year period. (Assume that the price of either bond was initially equal to its respective par value)

Uncertainty of investors about corporate performance in the future.

When stock market volatility is high, corporate bond yields tend to increase. What market forces cause the increase in corporate bond yields under these conditions?

The crisis led to an anticipated shortage of oil, which can fuel inflation. Those countries that rely on imported oil would be most affected. Since Japan imports all of its oil while the United Kingdom is self-reliant, Japan's inflation was more susceptible to the crisis. Therefore, Japan's bond prices would be expected to experience a greater decline (which they did).

When tensions rise or war erupts in the Middle East, bond prices in many countries tend to decline. What is the link between problems in the Middle East and bond prices? Would you expect bond prices to decline more in Japan or in the United Kingdom as a result of the crisis? (The answer is tied to how interest rates may change in those countries.) Explain.

The required rate of return on a bond changes because of a change in interest rates, or a change in the risk of the bond

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

If British interest rates increased or remained constant while U.S. interest rates declined, the U.S. bonds could have been sold at a much higher price than British bonds.

A U.S. insurance company purchased British 20-year Treasury bonds instead of U.S. 20-year Treasury bonds because the coupon rate was 2 percentage points higher on the British bonds. Assume that the insurance company sold the bonds after five years. Its yield over the five-year period was substantially less than the yield it would have received on the U.S. bonds over the same five-year period. Assume that the U.S. insurance company had hedged its exchange rate exposure. Given that the lower yield was not because of default risk or exchange rate risk, explain how the British bonds could have generated a lower yield than the U.S. bonds. (Assume that either type of bond could have been purchased at the par value.)

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A bond with a 10 percent coupon rate pays interest semiannually. Par value is $1,000. The bond has three years to maturity. The investors' required rate of return is 12 percent. What is the present value of the bond?

No, you should disagree with the conclusion of the analyst, because, despite the decline in the price due to higher credit risks, the price will rise as the possible economic recession tends to put downward pressure on interest rates and the overall effect is not obvious.

An analyst recently suggested that there will be a possible economic recession that will adversely affect the prices of high-rated fixed-rate bonds, because the credit risk of bonds will rise as corporations worsen their performance. Assuming that the economic recession occurs, do you agree with the conclusion of the analyst? Explain.

increase; downward

An expected ____ in economic growth tends to place ____ pressure on bond prices

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An insurance company purchases corporate bonds in the secondary market with six years to maturity. Total par value is $55 million. The coupon rate is 11 percent, with annual interest payments. If the expected required rate of return in four years is 9 percent, what will the market value of the bonds be then?

decrease by a greater degree than short-term bond prices.

As interest rates increase, long-term bond prices

A recession tends to imply a reduced demand for loanable funds and therefore lower interest rates and higher prices for existing bonds. As bond portfolio managers purchase their bonds based on this expectation, there is immediate upward pressure on bond prices.

Assume that breaking news causes bond portfolio managers to suddenly anticipate a recession. How might bond prices be affected by this expectation? Explain.

Since lower inflation normally causes a decline in interest rates (other things being equal), financial institutions would benefit if they increase their concentration of long-term bonds before this occurs

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 in long-term bonds based on this expectation? Explain.

Increase in oil production implies lower oil prices, lower interest rates, and higher bond prices

Assume that oil-producing countries have agreed to increase their oil production by 30 percent. How would bond prices be affected by this announcement? Explain.

a. Assuming no threat of deflation, how would bond prices be affected by this expectation? Without the threat of deflation, a decrease in the money supply could increase interest rates and bond prices would decline b. Assuming that deflation may result, how would bond prices be affected? If deflation increases, interest rates will likely reduce, and prices of existing bonds will increase

Assume that the bond market participants suddenly expect the Fed to substantially decrease the money supply

greater; more

Assume that the value of a financial institution's liabilities equals that of its assets. If the durations of its asset portfolio are ____ than the durations of its liability portfolio, then the market value of the assets is ____ interest-rate sensitive than the market value of the liabilities.

A lower and less steeper yield curve implies that long-term bond yields have decreased. Therefore, the firm would sell the bonds for higher

Assume that there is a sudden shift in the yield curve, such that the new yield curve is lower and less steeply sloped today than it was yesterday. If a firm issues new bonds today, would its bonds sell for higher or lower prices than if it had issued the bonds yesterday? Explain.

Assume that the yield curve is flat today. Explain how the slope of the yield curve will change tomorrow in response to the market activity. The yield curve will become upward-sloping because the yield offered on bonds will rise, while the yield offered on money market securities will decline

Assume that you maintain bonds and money market securities in your portfolio, and you suddenly believe that long-term interest rates will rise substantially tomorrow (even though the market does not share the same view), while short-term interest rates will remain the same.

How would you rebalance your portfolio between bonds and money market securities? Based on your expectations, bond prices will decline You should rebalance your portfolio by selling bonds and purchasing more money market securities

Assume that you maintain bonds and money market securities in your portfolio, and you suddenly believe that long-term interest rates will rise substantially tomorrow (even though the market does not share the same view), while short-term interest rates will remain the same.

If the market suddenly recognizes that long-term interest rates will rise tomorrow, and that they respond in the same manner as you, explain how prices and yields of these securities (bonds and money market securities) will be affected. Bond prices will decline, while the prices of money market securities will rise as investors rebalance their portfolios. Consequently, the yield offered on bonds will rise, and the yield offered on money market securities will decline

Assume that you maintain bonds and money market securities in your portfolio, and you suddenly believe that long-term interest rates will rise substantially tomorrow (even though the market does not share the same view), while short-term interest rates will remain the same.

A lower trade deficit figure signals the possibility of continued low trade deficits, which would place upward pressure on the dollar. As the dollar strengthens, U.S. inflation may decline, and U.S. interest rates may decline. Thus, bond portfolio managers buy bonds, placing upward pressure on bond prices.

Bond portfolio managers closely monitor the trade deficit figures, because the trade deficit can affect exchange rates, which can affect inflationary expectations and therefore interest rates. When the trade deficit figure is lower than anticipated, bond prices typically increase. Explain why this reaction may occur.

below; below

Consider a coupon bond that sold at par value two years ago. If interest rates are much higher now than when this bond was issued, the coupon rate of that bond will likely be ____ the prevailing interest rates, and the present value of the bond will be ____ its par value.