Things to remember o the price of bonds and the

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Things to remember: o The price of bonds and the interest rate are negatively related. o When expected in inflation rises, the supply and demand curve move in such a way that causes the price of bonds to decrease, causing an increase in the interest rate. o So when expected inflation rises, the interest rate will rise. Japan and low interest rates: o In 1998, interest rates on Japanese 6 month treasury bills turned slightly negative. o During this time, Japan experience a prolonged recession, which was accompanied by deflation, a negative inflation rate. Negative inflation caused the demand for bonds to rise because the expected return on real assets fell, thereby raising the relative expected return on bonds and in turn causing the demand curve to shift to the right. The negative inflation rate also raised the real interest rate and therefore the real cost of borrowing for any given nominal rate, thereby causing the supply of bonds to contract and the supply curve to shift to the left. o These changes led to a rise in the bond price and a fall in interest rates. Chapter 5 One attribute of a bond that influences its interest rate is its risk of default, which occurs then the issuer of the bond is unable or unwilling to make interest payments when promise or to pay the face value when the bond matures. Treasury bills are considered default-free bonds. The spread between the interest rates on bonds with default risk and default- free bonds, both of the some maturity, called the risk premium, indicates how much additional interest people must earn to be wiling to hold that risky bond. Risk premiums also take into account liquidity. The less liquid an asset is, the higher its risk premium. A bond with default risk always has a positive risk premium. The higher the default risk, the larger the risk premium will be.
Junk bonds (speculative grade): Bonds with ratings below Baa (or BBB). These bonds have higher interest rates than investment grade securities and therefore are referred to as high yield bonds. Municipal bonds have higher risk than treasury bonds yet they have lower interest rates. This is because of the fact that municipal bonds are exempt from federal income taxes, a factor that has the same effect on the demand for municipal bonds as an increase in their expected return. The risk structure of interest rates (the relationship among interest rates on bonds with the same maturity) is explained by three factors: default risk, liquidity, and the income tax treatment of a bonds interest payments. Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is different. A plot of the yields on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations is called a yield curve, and it describes the term structure of interest rates for particular types of bonds. Yield curve can be classified as upward sloping, flat, and downward sloping. Downward sloping = inverted yield curve When the yield curve slopes upward, the long term interest rates are above the short term interest rates.

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