FINA2330 CDE Tutorial 2
Financial Market and Institutions
Topic 2: Interest Rates
Topic 3: Bond Demand and Supply
Chapter 3 Interest rates
Bond price formula
𝐶𝐹𝑡 𝐶𝑡 𝐹𝑉𝑛
𝑃 = σ𝑛𝑡=1 = σ𝑛𝑡=1 +
(1+𝑖)𝑡 (1+𝑖)𝑡 (1+𝑖)𝑛
i: yield to maturity
n: number of periods
Coupon (C): Face Value (FV) * Coupon Rate
Coupon payments are made annually unless otherwise stated.
Rate of return
𝐶+𝑃𝑡+1 −𝑃𝑡
Total return on bond =
𝑃𝑡
= current yield + capital gains yield
𝐶
Current yield =
𝑃𝑡
𝑃𝑡+1 −𝑃𝑡
Capital gains yield =
𝑃𝑡
Interest rate risk & Reinvestment risk
Interest rate risk
Occurs when uncertainty of bond’s return due to fluctuations of interest
rates
When bond price drops, interest rate
Matters when you plan to sell the bond before maturity
More relevant for long term bonds
Reinvestment risk
Occurs when the proceeds from the short-term bond need to be reinvested
at an uncertain future interest rate
when bond price rises, interest rate
Matters when you plan reinvest into another bond after the current
investment matures
More relevant for short term bonds
Duration
Duration is a measure of interest rate risk
𝐶𝐹𝑡
σ𝑛
𝑡=1 𝑡 (1+𝑖)𝑡 𝐶𝐹𝑡
𝐷𝑢𝑟 = , where 𝑃 = 𝑛
σ𝑡=1
𝑃 (1+𝑖)𝑡
Duration measured in time unit (usually in years)
Duration longer when:
Longer maturity (larger n)
Lower coupon rate
Lower YTM
Duration
Approximate bond price change formula:
∆𝑃 ∆𝑖
≈ −𝐷𝑢𝑟
𝑃 (1+𝑖)
Longer duration = bond price more volatile
Same interest rate change, more price change
Chapter 4 Bond demand and supply
Current Price = 850
Quantity transacted =
300 billion
Quantity demanded
= quantity supplied
When will bond price change?
Bond price rises when:
Demand curve shifts right
Supply curve shifts left
Bond price drops when:
Demand curve shifts left
Supply curve shifts right
Factor affecting bond demand
Wealth Demand
Expected interest rate (Long term bond)Demand
Expected inflation Demand
Riskiness relative to other assets Demand
Liquidity relative to other assets Demand
Factor affecting bond supply
Expected inflation Supply
Government deficit Supply
Profitability of business Supply
Fisher effect: Expected inflation , demand supply
YTM together with expected inflation
When expected interest rate rises, which type of
bonds should you buy as a bond investor?
Buy short term bonds
Reasoning:
Expected Interest rate in future, reinvest the money at
higher interest rate
When expected interest rate rises, which type of
bonds should you issue as a bond issuer?
Borrow long term (issue long term bonds)
Reasoning:
Borrow short term is bad due to higher borrowing cost
Borrow long term allow you to fix interest rate
Discussion
Please work on Tutorial 2 Practice Questions for
exercises.
Practice Questions 2 Q2
The duration of a ten-year, 10 percent coupon bond when the
interest rate is 10 percent is 6.76 years. What happens to the price of
the bond if the interest rate falls to 8 percent?
A) It rises 20 percent.
B) It rises 12.3 percent.
C) It falls 20 percent.
D) It falls 12.3 percent.
Practice Questions 2 Q7
When people begin to expect a large run up in stock prices, the
demand curve for bonds shifts to the ________ and the interest rate
________.
A) right; rises
B) right; falls
C) left; falls
D) left; rises
Practice Questions 2 Q8
Factors that cause the demand curve for bonds to shift to the left
include
A) an increase in the inflation rate.
B) an increase in the liquidity of stocks.
C) a decrease in the volatility of stock prices.
D) all of the above.
E) none of the above.
Practice Questions 2 Q13
Calculate the duration of a $1,000 6% annual coupon bond with three
years to maturity. Assume that all market interest rates are 7%.