Money and Banking: Lecture 14 provides students with content about: yield to maturity; current yield; holding period returns; bond supply and demand; factors affecting bond supply; factors affecting bond demand;... Please refer to the lesson for details!
Money and Banking Lecture 14 McGrawHill/Irwin Copyright © 2006 by The McGrawHill Companies, Inc. All rights reserved Review of the Previous Lecture • Bond & Bond pricing • • • • Zero Coupon Bond Fixed Payment Loan Coupon Bonds Consols • Bond Yield • Yield to Maturity • Current Yield 6-2 Topics under Discussion • • • • • • Yield to Maturity Current Yield Holding Period Returns Bond Supply & Demand Factors affecting Bond Supply Factors affecting Bond Demand 6-3 Yield To Maturity • General Relationships • If the yield to maturity equals the coupon rate, the price of the bond is the same as its face value • If the yield is greater than the coupon rate, the price is lower; • if the yield is below the coupon rate, the price is greater 6-4 Yield To Maturity • If you buy a bond at a price less than its face value you will receive its interest and a capital gain, which is the difference between the price and the face value • As a result you have a higher return than the coupon rate • When the price is above the face value, the bondholder incurs a capital loss and the bond’s yield to maturity falls below its coupon rate 6-5 6-6 Current Yield • Current yield is a commonly used, easy-tocompute measure of the proceeds the bondholder receives for making a loan • It is the yearly coupon payment divided by the price Current Yield Yearly Coupon Payment Price Paid 6-7 Current Yield • The current yield measures that part of the return from buying the bond that arises solely from the coupon payments; • it ignores the capital gain or loss that arises when the bond’s price differs from its face value 6-8 Current Yield • Let’s return to 1-year 5% coupon bond assuming that it is selling for $99 • Current yield is 5/99 = 0.0505 or 5.05% • YTM for this bond is calculated to be 6.06% through the following calculations $5 (1 i ) $100 = $99 (1 i ) • If you buy the bond for $99, one year later you get not only the $5 coupon payment but also a guaranteed $1 capital gain, totaling to $6 • Repeating this process for the bond selling for $101, current yield is 4.95% and YTM is 3.96% 6-9 Current Yield • The current yield moves inversely to the price; • If the price is above the face value, the current yield falls below the coupon rate • When the price falls below the face value, the current yield rises above the coupon rate • If the price and the face value are equal the current yield and the coupon rate are equal 6-10 Bond Supply, Demand and Equilibrium • If the price is too high (above equilibrium) the excess supply of bonds will push the price back down • If the price is too low (below equilibrium) the excess demand for bonds will push it up • Over time the supply and demand curves can shift, leading to changes in the equilibrium price 6-27 Factors that shift Bond Supply • Changes in government borrowing • Any increase in the government’s borrowing needs increases the quantity of bonds outstanding, shifting the bond supply curve to the right • This reduces price and increases the interest rate on the bond 6-28 Factors that shift Bond Supply • Changes in business conditions • business-cycle expansions mean more investment opportunities, prompting firms to increase their borrowing and increasing the supply of bonds • As business conditions improve, the bond supply curve shifts to the right • This reduces price and increases the interest rate on the bond • By the same logic, weak economic growth can lead to rising bond prices and lower interest rates 6-29 Factors that shift Bond Supply • Changes in expected inflation • Bond issuers care about the real cost of borrowing, • So if inflation is expected to increase then the real cost falls and the desire to borrow rises, resulting in the bond supply curve shifting to the right • This reduces price and increases the interest rate on the bond 6-30 Factors that shift Bond Supply 6-31 Factors that shift Bond Supply 6-32 Factors that shift Bond Demand • wealth • An increases in wealth shift the demand for bonds to the right as wealthier people invest more • This will happen as the economy grows during an expansion • This will increase Bond Prices and lower yields 6-33 Factors that shift Bond Demand • Expected inflation • A fall in expected inflation shifts the bond demand curve to the right, increasing demand at each price and lowering the yield and increasing the Bond’s price 6-34 Factors that shift Bond Demand • Expected return on stocks and other assets • If the return on bonds rises relative to the return on alternative investments, the demand for bonds will rise • This will increase bond prices and lower yields 6-35 Factors that shift Bond Demand • Risk relative to alternatives • If a bond becomes less risky relative to alternative investments, the demand for the bond shifts to the right 6-36 Factors that shift Bond Demand • Liquidity of bonds relative to alternatives • When a bond becomes more liquid relative to alternatives, the demand curve shifts to the right 6-37 Factors that shift Bond Demand 6-38 Factors that shift Bond Demand 6-39 Bonds and Risk Sources of Bond Risk • Default Risk • Inflation Risk • Interest-Rate Risk 6-40 Summary • • • • • Yield to Maturity Current Yield Holding Period Returns Bond Supply Bond Demand 6-41 ... things being equal 6-25 Bond Supply, Demand and Equilibrium Equilibrium in the bond market is the point at which supply equals demand 6-26 Bond Supply, Demand and Equilibrium • If the price is too... Prices and lower yields 6-33 Factors that shift Bond Demand • Expected inflation • A fall in expected inflation shifts the bond demand curve to the right, increasing demand at each price and lowering... Supply, Demand and Equilibrium Bond Supply For a $100 one-year zero-coupon bond, the supply will be higher at $95 than it will be at $90, all other things being equal 6-23 Bond Supply, Demand and Equilibrium