Bond+Market+Mechanics+-+Part+1+-+F11

Bond+Market+Mechanics+-+Part+1+-+F11 - BOND MARKET...

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Unformatted text preview: BOND MARKET MECHANICS - I Interest Rates Moving Together Bond Market Mechanics Bond • Outline: – Interest rates move together • Event Driven – – – – Budget deficits OMO Economic Growth Expected Inflation » Real interest rates and the Fisher Effect – Interest Rate Spread • Risk • Time to maturity • Taxes Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I Interest rates move together Interest Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I Bond Market Mechanics Bond • Interest rates move together – Event Driven • • • • Budget deficits OMO Economic Growth Expected Inflation – Real Interest Rates and the Fisher Effect Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I Interest rates move together Interest FBD Federal Budget Surplus and Deficits (-) Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I Interest rates move together Interest FBD Federal Budget Debt Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I Interest rates move together Interest FBD • Bond Market Bond Equilibrium Equilibrium Price Bsj – At P* • B d j = B sj P* Bd j Quantity Quantity Eco 301 - Fall 2011 – Federal Budget Deficits leads to an increased supply of bonds, shifting Bs curve out (left). Nick Noble Bond Market Mechanics - I Interest rates move together Interest FBD • Bond Market Bond Equilibrium Equilibrium Price Bsj Bsj(FBD>0) P* P** Bd j Quantity Quantity Eco 301 - Fall 2011 – New Bond Supply curve lowers bond prices and increase the interest rate on that bond. – Price falls from P* to P** – Interest Rate on this bond will increase!! Nick Noble Bond Market Mechanics - I Interest rates move together Interest FBD • Bond J – The one the Treasury used to finance the deficit • Bond K – Some other bond • Corporate, • Government • State and Local Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I Interest rates move together Interest FBD Price Price Bond J Bond K Bsj Bs K Bsj(FBD>0) Pj * Pk* Pj** Pk** Bd j BD K BD K (i j ↑) Quantity Quantity Eco 301 - Fall 2011 Quantity Quantity Nick Noble Bond Market Mechanics - I Interest rates move together Interest FBD • FBD Summary – Bond J Bond • The one the Treasury used to finance the deficit – Bond Supply increases – Price bond J falls – Interest rate on bond j increases – Bond K • Some other bond – Bond Demand falls (since the interest rate rises on another assets – bond j ) – Price bond K falls – Interest rate on bond K increases – FBD>0 Interest rates of both Bond J and K FBD>0 increase increase Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I Interest rates move together Interest Open Market Operations (OMO) Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I Interest rates move together Interest • Open Market Operations. – To increase the money supply (lower interest rates) the Fed buys securities from the public (other things equal). • OMO + – To decrease the money supply (increase interest rates) the Fed sells securities to the public (other things equal). • OMO- Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I Interest rates move together Interest OMO • Bond Market Bond Equilibrium Equilibrium Price Bsj – At P* • B d j = B sj P* Bd j – Expansionary Open Expansionary Market Operations the FED buys securities FED • Bs of that security will fall Quantity Quantity Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I Interest rates move together Interest OMO + Price Bsj(OMO+) Bsj • Bond Market Bond Equilibrium Equilibrium – New Bond Supply curve increases bond prices and reduces the interest rate on that bond. P** P* Bd j – Price rise from P* to P** Quantity Quantity Eco 301 - Fall 2011 – Interest Rate on this bond will fall!! Nick Noble Bond Market Mechanics - I Interest rates move together Interest OMO + • Bond J Bond – The one the Fed purchased in the open market transaction • Bond K – Some other bond Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I Interest rates move together Interest Price OMO + Bond J Bsj(OMO+) Price Bond K Bsj Bsk Pj** PK** Pj * Pk* Bdk (i j ↓) Bd j Quantity Quantity Eco 301 - Fall 2011 Bd k Quantity Quantity Nick Noble Bond Market Mechanics - I Interest rates move together Interest OMO + • OMO(+) Summary – Bond J • The one the Fed purchased in the open market transaction – Bond Supply decreases – Price Bond J increases – Interest rate on bond J falls – Bond K • Some other bond – Bond demand of bond K increases (since (ij ↓) – Price of bond K increases – Interest rate on bond K falls – OMO + Decrease in interest rates on Bond J OMO and K. and Nick Noble Eco 301 - Fall 2011 Bond Market Mechanics - I Interest rates move together Interest Growth • Bond Market Bond Equilibrium Equilibrium Price Bsj – At P* • B d j = B sj P* • Economic Growth Bd j – Increase Bus Opportunities • Increase Bond Supply – Increase Wealth Quantity Quantity Eco 301 - Fall 2011 • Increase Bond Demand Nick Noble Bond Market Mechanics - I Interest rates move together Interest Growth - 1 • Bond Supply and Bond Demand change equal amount amount Price Bsj Bsj(Bus Opp ↑) P* Bdj (Wealth↑ ) – Bond Prices and interest rates do not change. Bd j Quantity Quantity Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I Interest rates move together Interest Growth - 2 • Bond Demand Bond changes by more than bond supply. bond Price Bsj P** P* Bsj(Bus Opp ↑) Bdj (Wealth↑ ) – Bond Prices rise and interest rates fall. Bd j Quantity Quantity Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I Interest rates move together Interest Growth - 3 Price • Bond supply changes Bond B by more than bond B (Bus Opp ↑) demand. demand s j s j – Bond Prices fall and interest rates increase. P* P** Bdj (Wealth↑ ) Bd j Quantity Quantity Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I Interest rates move together Interest Growth • Bond demand and supply change by the same amount. – Interest rates do not change. • Bond supply changes more than bond demand. – Bond prices fall and interest rates rise. • Bond demand changes by more than bond supply. – Bond prices rise and interest rates fall • Growth Uncertain effect on interest rates. Growth Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I Interest rates move together Interest Expected Inflation – πe Expected • Real Interest rate – Interest rate adjusted for inflation – Real rate = i - πe • Backward looking – June 2008 interest rate on a one year bond was 2.42. The inflation rate between June 2007 and June 2008 was -1.15, which implies a real interest rate of 3.57 (2.42-(-1.15))=3.57) • Forward looking – i – πe i now less inflation expected over next year. The June 2008 one year bond interest rate was 2.42 and the U of Michigan expected inflation rate was 3.1 or a real rate of -0.68. (2.42-3.10=-0.68) Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I Interest rates move together Interest Expected Inflation – πe Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I Interest rates move together Interest Expected Inflation – πe Expected Price Price Bsj Bsj(πe ↑) • Bond supply Bond increases and bond demand falls. demand – Bond Prices fall and interest rates increase. P* P** Bd j Bdj (πe ↑ ) Quantity Quantity Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I Interest rates move together Interest Expected Inflation – πe Expected • Expected Inflation – Πe ↑ Bond Prices ↓ , i↑ • Fisher Effect Fisher – Increases in expected inflation increase nominal interest rates – Real rates? • Πe ↑ , i ↑, then i- πe is uncertain. Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I Interest rates move together Interest Expected Inflation – πe Expected Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I Bond Market Mechanics Bond • Interest rates move together – Event Driven • Budget deficits – FBD>0 i ↑ • OMO – OMO + i ↓ • Economic Growth – Growth i ? • Expected Inflation – Πe ↑ i ↑, but real i ? Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - I ...
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This note was uploaded on 10/19/2011 for the course ECON 301 taught by Professor Staff during the Spring '11 term at Miami University.

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