Bond Market Mechanics Part 2

Bond Market Mechanics Part 2 - Bond Market Mechanics - II...

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Unformatted text preview: Bond Market Mechanics - II II Interest Rate spreads 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 Taxes Time to maturity Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 2 Interest rates at a point in time. Interest Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 3 Interest rates at a point in time. Interest • Interest Rate Spread – Risk – Taxes – Time to maturity Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 4 Risk and Interest rates Risk • Risk – Other things equal, savers prefer assets with less risk to assets with more risk. – Bdj = f( (ij-ik), (σj – σk), (Lj – lk), W) • (σj – σk) Relative risk (-) – Risk increase Bdj shifts in Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 5 Risk and Interest rates Risk Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 6 Risk and Interest rates (σj = σk) Price Price Bond K= RiskFree Gov’t Bond Price Bond Bond Bond J Bsj Pj * Bs K Pj* ij0 Pk* Pk* ik0 Bd j BD K Quantity Quantity Eco 301 - Fall 2011 Quantity Quantity Nick Noble Bond Market Mechanics - II 7 Risk and Interest rates Risk (σj > σk) Price Price Price Bond J Bond K= RiskFree Gov’t Bond Bsj Bs K Pj* ij0 Pk ↑ ik0 ↓ Pj * Pk* Pk* ik0 BD K (σj > σk) Bdj (σj = σk) Pj ↓ ij0 ↑ Quantity Quantity Eco 301 - Fall 2011 Bdj (σj > σk) BD K (σj = σk) Risk Premium Quantity Quantity Nick Noble Bond Market Mechanics - II 8 Risk and Interest rates Risk • Bonds with higher risk Bonds should have higher interest rates. interest • Risk Premium Risk – the difference between a bond interest rate and the interest rate on a risk free bond. Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 9 Taxes and Interest rates Taxes • Municipal Bonds – No Federal Income tax. • Interest rate on Government Bond – ig0 – Tax rate = t Tax – Tax paid = ig0 *t Tax – After tax interest rate = ig0 - ig0 *t = ig0 (1-t) After Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 10 Taxes and Interest rates ig0 = im0 Price Price Price Gov’t bond Municipal bond Bsg Pg * Bs m Pg* ig0 Pm * Pm* im0 Bd g BD m Quantity Quantity Eco 301 - Fall 2011 Quantity Quantity Nick Noble Bond Market Mechanics - II 11 Taxes and Interest rates Taxes • After tax rates – Government bond • ig0 (1-t) – Municipal bond • im0 • We would expect : – im0 = ig0 (1-t) Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 12 Taxes and Interest rates Price Price Price Gov’t bond Municipal bond BsG im0 ↓ Pg* ig0 Pg * ig0 ↑ Bs M Pm * Pm* im0 Bd g BD M Bdg (tg>0) Quantity Quantity Eco 301 - Fall 2011 BD M (tm=0) Quantity Quantity Nick Noble Bond Market Mechanics - II 13 Taxes and Interest rates Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 14 Time to maturity and interest rates rates Yield Curve – Web Link – “Fun” yield curve WWW site Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 15 Yield Curve Shapes Yield Ascending (Normal) yield curve i Time to maturity Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 16 Yield Curve Shapes Flat yield curve i Time to maturity Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 17 Yield Curve Shapes Yield Descending (inverted) yield curve i Time to maturity Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 18 Yield Curve “Facts” Yield • Interest Rate Move together • Three Shapes • “Usually” the yield curve is ascending Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 19 Yield Curve Yield • Expectations Theory – Save (Buy financial assets) • Two year time horizon – Buy a 2 year bond (i2y) – Buy 1 year bond (i1y) and then a second one year bond one year in the future (i1ye) • Returns – 2 year = (1+2 i2y ) – 1 year = (1 + i1y + i1ye) Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 20 Yield Curve Yield • Expectations Theory – Savers view long-term ( 2 year bonds) and short-term bonds (1 year) as perfect substitutes. • Choose the bond with the highest interest rate. – (1+2 i2y ) = (1 + i1y + i1ye) +i – (2 i2y ) = ( ii1y + i e1ye) – or Eco 301 - Fall 2011 i 2y = 1y 1y 2 Nick Noble Bond Market Mechanics - II 21 Yield Curve Yield • Expectations Theory – Long term interest rate (2 year bond rates - i 2y - ) tend to be an average of current short term rates (1 year bond rates – i1y - ) and expected future short-term bond rates (- i1ye - ). e i1y + i1y i 2y = 2 Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 22 Yield Curve Yield • Expectations Theory i1y 5% 5% 5% i1y e 7% 5% 3% i2y 6% 5% 4% Yield curve Ascending Flat Inverted Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 23 Yield Curve Yield • Expectations Theory – Can explain: • Three shapes • Move together – Can not explain: • “Usually ascending. Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 24 Yield Curve Yield • Preferred habitat Preferred – Like expectations theory, but long and short term bonds are not prefect substitutes for each other. – If – Then savers will prefer the short term bond. Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 25 Yield Curve Yield • Preferred habitat Preferred – As savers buy short term bonds (do not buy long term bonds) • Short term bonds – Demand increases – Prices rise – Interest rates fall • Long term bonds – Demand falls – Prices fall – Interest rates increase. Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 26 Yield Curve Yield Preferred habitat Preferred e i1y (↓) + i1y i 2y (↑) = 2 Or: i 2y e i1y + i1y = + h2 2 h2 - premium associated with 2 year bonds Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 27 Yield Curve Yield • Preferred habitat Preferred h2 2% 2% 2% 2% 2% i1y 5% 5% 5% 5% 5% i1y e 7% 5% 3% 1% .5% i2y 8% 7% 6% 5% 4 ¾% Yield curve Ascendin g Ascendin g Ascendin g Flat Inverted Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 28 Yield Curve Yield • Preferred Habitat – Can explain: • Three shapes • Move together • Usually ascending Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 29 Yield Curve and Economic Activity Activity Eco 301 - Fall 2011 Nick Noble Bond Market Mechanics - II 30 ...
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This note was uploaded on 10/20/2011 for the course ECO 301 taught by Professor Sungu during the Fall '10 term at Miami University.

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