Interest Rates and Bond Markets: An Analysis of Supply and Demand, Assignments of Banking and Finance

Download Interest Rates and Bond Markets: An Analysis of Supply and Demand and more Assignments Banking and Finance in PDF only on Docsity! Econ 340, Fall 2009 Problem Set 3 Chapter 4: Questions 6, 11; 6. When the Fed sells bonds to the public, it increases the supply of bonds, thus shifting the supply curve Bs (S1 in the figure) to the right. At the old equilibrium price, P1, there is now excess supply of bonds measured by the distance AB= Q’’-Q1, in the figure below. An excess supply of bonds causes bond prices to fall. Because the price of a bond is just the present value of all future cash payments, and those cash payments are fixed, the falling bond price implies an increase in the yield to maturity on the bond. The new equilibrium bond price is shown as P2 in the figure below. Thus, as the Fed reduces the supply of money by increasing its sale of bonds, market interest rates rise. 11. We know from the theory of asset demand that investors do not like risk. Therefore, an increased riskiness of bonds will reduce the demand for bonds. The demand curve shifts to the left. At the old equilibrium price, P1, there is now excess supply of bonds measured by the distance AB= Q’’-Q1, in the figure. An excess supply of bonds causes bond prices to fall. Because the price of a bond is just the present value of future cash payments, and those cash payments are fixed, the falling bond price implies an increase in the yield to maturity on the bond. The new equilibrium bond price is shown as P2 in the figure below. Thus, an increase in the riskiness of bonds results in an increase in interest rates on those bonds. Chapter 4: Quantitative Problems 1, 4 1. You own a $1,000-par zero-coupon bond that has 5 years of remaining maturity. You plan on selling the bond in one year, and believe that the required yield next year will have the following probability distribution: Probability Required Yield 0.1 6.60% 0.2 6.75% 0.4 7.00% 0.2 7.20% 0.1 7.45% a. What is your expected price when you sell the bond? b. What is the standard deviation? Solution Probability Required Yield Price Prob × Price Prob × (Price − Exp. Price)2 0.1 6.60% $774.41 $ 77.44 12.84776241 0.2 6.75% $770.07 $154.01 9.775668131 0.4 7.00% $762.90 $305.16 0.013017512 0.2 7.20% $757.22 $151.44 6.862609541 0.1 7.45% $750.02 $ 75.02 16.5903224 $763.07 46.08937999 The expected price is $763.07. The variance is $46.09, or a standard deviation of $6.79.