12.1 Understanding Bonds

Question 1

For simplicity, what two catagories are we grouping financial wealth into?

Answer 1

To simplify our discussion, we will group financial wealth into just two categories, which we call “money” and “bonds.”

This simplification is useful because it emphasizes the important distinction between interest-earning and non-interest-earning assets, a distinction that is central for understanding the demand for money.

Question 2

What do we mean by money?

Answer 2

By money we mean all assets that serve as a medium of exchange—that is, paper money, coins, and bank deposits that can be transferred on demand by cheque or electronic means.

Question 3

What do we mean by bonds?

Answer 3

By bonds we mean all other forms of financial wealth; this includes interest-earning financial assets and ownership shares in firms.

A bond is a financial asset that promises to make one or more payments at specified dates in the future.

Question 4

What is Present Value (PV) ?

Answer 4

Present value (PV)

The value now of one or more payments or receipts made in the future; often referred to as discounted present value.

Question 5

What does present value depend on?

Answer 5

Present value depends on the market interest rate because when we calculate present value, the interest rate is used to discount the value of the future payments to obtain their present value.

Question 6

Example of how you would calculate Present value if you wanted to have 100$ a year from now at 5% interest.

Answer 6

Question 7

What is the Equation for Present Value (PV) ?

Answer 7

Question 8

Equation for PV with sequences of cupon payments

Answer 8

Question 9

What is “face value”?

Answer 9

Some make no coupon payments and only a single payment (the “face value”) at some point in the future.

Question 10

What are short term government bonds called?

Answer 10

This is the case for short-term government bonds called Treasury bills.

Question 11

What do all bonds have in common?

Answer 11

They promise to make some payment or sequence of payments in the future.

Question 12

Are bonds positivly or negativly related to the market interest rate?

Answer 12

The present value of any bond that promises one or more future payments is negatively related to the market interest rate.

Question 13

What does the Present value of a bond represent?

Answer 13

The present value of a bond is the most someone would be willing to pay now to own the bond’s future stream of payments.

Question 14

What happens to the demand for a bond when the price is above the bond’s present value?

Answer 14

Thus, at any price above the bond’s present value, the lack of demand for that bond will cause its price to fall.

Question 15

What happens to the dmeand for a bond when its price is below present value?

Answer 15

At any price below the bond’s present value, the abundance of demand for that bond will cause its price to rise.

Question 16

What determines the equilibrium market price of a bond?

Answer 16

The equilibrium market price of any bond is determined by the present value of the income stream that it produces.

Question 17

We now have two relationships that can be put together to tell us about the link between the market interest rate and bond prices….

Answer 17

The present value of any given bond is negatively related to the market interest rate.

A bond’s equilibrium market price will be equal to its present value.

Question 18

What is the relationshio between the market interest rate and the price of a given bond?

Answer 18

An increase in the market interest rate leads to a fall in the price of any given bond.

A decrease in the market interest rate leads to an increase in the price of any given bond.

Question 19

A bond is a financial investment for…

Answer 19

Remember that a bond is a financial investment for the purchaser.

The cost of the investment is the price of the bond, and the return on the investment is the sequence of future payments.

Question 20

What does a lower bond price imply for a given sequence of future payments?

What is a bond yield?

Answer 20

Thus, for a given sequence of future payments, a lower bond price implies a higher rate of return on the bond, or a higher bond yield.

Question 21

What is the difference between the yield of a bond and the market interest rate?

Answer 21

The yield on any specific bond is a function of that bond’s sequence of payments and its purchase price.

The market interest rate is the rate at which you can borrow or lend money in the credit market.

Question 22

What is the relationship between the market interest rate and bond yields?

Answer 22

An increase in the market interest rate will reduce bond prices and increase bond yields.

A reduction in the market interest rate will increase bond prices and reduce bond yields. Therefore, market interest rates and bond yields tend to move together.

Thus, we see that market interest rates and bond yields tend to move in the same direction.

Question 23

Why do economists discussing the role of moeny in the macroeconomy typically refer to “the” interest rate or “interest rates” in general rather then specific interest rates among many different rates corrosponding to different financial assets?

Answer 23

Because of this close relationship between bond yields and market interest rates, economists discussing the role of money in the macroeconomy typically refer to “the” interest rate—or perhaps to “interest rates” in general—rather than to any specific interest rate among the many different rates corresponding to the many different financial assets.

Since these rates all tend to rise or fall together, it is a very useful simplification to refer only to “the” interest rate, meaning the rate of return that can be earned by holding interest-earning assets rather than money.

Question 24

How do purchasers of bonds repond to riskier bonds?

Answer 24

In the face of this possibility, purchasers of bonds reduce the price they are prepared to pay by an amount that reflects the likelihood of non-repayment.

Question 25

What does an increase in the riskiness of a bond lead to?

Answer 25

An increase in the riskiness of any bond leads to a decline in its expected present value and thus to a decline in the bond’s price. The lower bond price implies a higher bond yield.

Question 26

Why are government bonds percieved as less risky?

Answer 26

In general, however, since governments have the power to collect revenue through taxation, it is unusual for a government bond to be viewed as a risky asset.

Question 27

Why are there typically higher yields in corporate bonds?

Answer 27

More usual at any given time is specific corporations that are believed to be in precarious financial situations and thus their bonds are perceived to be risky assets. As a result, there are often very high yields (low bond prices) on specific corporate bonds.

Question 28

How can bonds differ from each other?

Answer 28

Millions of bonds are traded every day, and they differ in terms of the issuer, price, yield, riskiness, and term to maturity.

Question 29

What is the issuer of a bond?

Answer 29

Issuer. This is the issuer of the bond—that is, the borrower of the money. The first five bonds shown are issued by the Government of Canada. The last two are issued by large private-sector firms.

Question 30

What is the Coupon of a bond?

Answer 30

Coupon. This is the coupon rate—the annual rate of interest that the bond pays before it matures. For example, a 4 percent coupon rate means that the bondholder (the lender) will receive 4 percent of the face value of the bond every year until the bond matures.

Question 31

What is the Maturity of a bond?

Answer 31

Maturity. This is when the bond matures and the face value is repaid to the bondholder. All debt obligations are then fulfilled.

Question 32

What is the Price of a bond?

Answer 32

Price. This is the market price of the bond (on March 18, 2021), expressed as the price per $100 of face value.

For example, a price of $105.70 would mean that for every $100 of face value, the purchaser must pay $105.70.

When the price is greater than $100, we say there is a premium; when the price is less than $100, we say the bond is selling at a discount.

Question 33

What is the Yield of a bond?

Answer 33

Yield. This is the rate of return earned by the bondholder if the bond is bought at the current price and held to maturity, earning all regular coupon payments.

Question 34

What is the relationship between bond price and coupon rate?

Answer 34

First, for a given issuer and maturity, there is a positive relationship between the bond price and the coupon rate.

Question 35

What is the relationship between bond yield and the term to maturity?

Answer 35

For a given bond issuer, there is a positive relationship between the bond yield and the term to maturity.

This positive relationship is often referred to as the yield curve or the term structure of interest rates.

The higher yields on longer-term bonds reflect what is often called a term premium—the higher yield that bondholders must be paid in order to induce them to have their money tied up for longer periods of time.

Question 36

What is the relationship between bond yield and the perceived riskiness of the bond issuer?

Answer 36

for a given term to maturity, there is a positive relationship between the bond yield and the perceived riskiness of the bond issuer.