chap006 - Chapter 6 Bonds Bond Prices and the Determination...

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Chapter 6 Bonds, Bond Prices, and the Determination of Interest Rates Chapter Overview If we want to understand the financial system, particularly the bond market, we must understand the relationship between bond prices and interest rates, the determination of bond prices in the market (by supply and demand), and also why bonds are risky. These issues will be covered in this chapter. Reading this chapter will prepare students to: Calculate the value of a bond by applying present value techniques. Assess the yields on bonds with different characteristics. Explain changes in the supply of and demand for bonds and their attendant effects on the bond market. Define the three types of risk associated with bonds (default risk, inflation risk, and interest-rate risk). Important Points of the Chapter Any financial arrangement involving the current transfer of resources from a lender to a borrower, with a transfer back at some time in the future, is a form of a bond. The ease with which individuals, corporations, and governments borrow is essential to the functioning of our economic system. While the depth and complexity of bond markets has increased in modern times, many of their original features (dating back to the 16 th and 17 th centuries) remain. Application of Core Principles Principle #1: Time (page 122) The price of a Treasury bill is the present value of the future payments it will make. The shorter the time period until the payments are made, the higher the price of the bond. Principle #4: Markets (page 131) Equilibrium in the bond market occurs when supply and demand are equal. At a higher price there would be an excess supply of bonds, which would push the price down. At a lower price there would be an excess demand for bonds, which would push the price up. Only when supply and demand are equal can there be equilibrium. Principle #2: Risk (page 135) Risk arises from the fact that an investment has many possible payoffs during the time horizon for which it is held. Certain risks affect the premium that investors require over the risk-free return. Risk requires compensation. 72 Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets
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Chapter 6 Bonds, Bond Prices, and the Determination of Interest Rates Teaching Tips/Student Stumbling Blocks This chapter continues the use of present value analysis to analyze how bond prices are determined. You may wish to begin with a review of the tools from Chapter 5. Spend time going carefully through the examples from the text and reinforce concepts by assigning end-of-chapter problems. Features in this Chapter Your Financial World : Know Your Mortgage (page 123) A large number of people with adjustable rate mortgages (ARMs) underestimate how much the interest rate can change. Important things to know are what interest-rate index the mortgage rate is based; how big is the mortgage rate margin above the interest-rate index on which it is based; how frequently the rate is adjusted; does it have an initial
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This note was uploaded on 02/12/2012 for the course ECON 101 taught by Professor Abrams during the Spring '11 term at Adams State University.

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chap006 - Chapter 6 Bonds Bond Prices and the Determination...

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