ECO349 Lecture #3 2019/09/23

BOND IS A TYPE OF FINANCIAL SECURITY

- fixed amount of cash flow at fixed dates, fixed maturity
- investors(=buyers) get the cash flow
- issuers(= sellers) raise the market price of the bonds
- Interest rate is the cost of borrowing and return if lending
- Calculate the interest rate of bonds
- YTM

SELLERS ≠ ISSUERS
- primary market: institutions (firms, government) that issue the security,
investment bank, institutional investors
- “securitites”: deposits, ​mortgages​, ​consumer loans​, etc.
- secondary market: dealers, individual investers
- increase the liquidity of securities
- securities traded : bonds, stocks, ​MBS​, ​ABS​, etc.

DISTINCTION BETWEEN YTM AND RATE OF RETURN

**(Lecture#2 slide starting from slide 60)
- Example 1: ​Consider a coupon bond of $1,000 face value, 10% coupon rate,
bought ar its face value, held for one year and sold for $1,200

($100+$1,200)
- $1,000 = (1+r)
=> ​r=30%​, where r: rate of return
- Example 2:​ Consider a two-year coupon bond of $1,000 face value, 10%
coupon rate, bought at its face value, held for one year and then sold.
Suppose that by the time the bond is sold, the interest rate rises from 10% to
30%. What is the rate of return of purchasing the bond?
- Crucial question: ​What is market price of the bond in one year (when
interest rate increases to 30%)?

- The decrease in price is so large that rate of return becomes ​negative

- Anyway that the investor could avoid the “nominal” loss? Hold the bond
until its maturity
- However, the opportunity cost is inevitable
INTEREST-RATE RISK
 - Interest-rate risk​: ​A rise in interest rates is associated with a fall in bond
prices, resulting in a capital loss
- The more distant a bond’s maturity, the greater the size of the percentage
price change associated with an interest- rate change, and thus the price of
the bond and its rate of return are more volatile

Lecture 3 slides:
SUPPLY AND DEMAND FRAMEWORK
Supply:
1. what does a supply curve tells you?
a. at given prices, how many kilos of apples a consumer is willing to buy
2. the shape of the supply curve?
a. upward sloping (X-axis: Quantity ; Y-axis: Price)
Demand:
1. what does a demand curve tells you?
a. at given prices, how many kilos of apples a consumer is willing to buy
2. the shape of the demand curve?
a. downward sloping (X-axis: Quantity ; Y-axis: Price)

SUPPLY AND DEMAND FOR BONDS

- Higher price, quantity of bonds ​supplied ​increases ​(P↑, Q​s​↑)
- Intuition​:​ Selling bonds is an act of​ ​borrowing.​ Higher price means the
borrower can raise more money at the same cost (because the cash flow of
bonds is fixed). Thus, more incentive to supply bonds.

- Higher price, quantity of bonds ​demanded ​declines ​(P↑, Q​D​↓)

- Intuition​:​ Buying bonds is an act of ​lending​. Higher price means the investor
paying more money for the same amount of return. Thus, less incentive to buy
bonds.

BOND MARKET EQUILIBRIUM

- So far, all other factors identical. When
prices change, how demand and supply
for bonds change →Shifts along the
curve!
- Interested in: What factors determine
equilibrium bond price?
- Factors that change people’s
incentive to buy and sell bonds
→Shifts of the curve
FACTORS THAT SHIFT BOND DEMAND
1. Wealth​: “Income effect”
2. Liquidity​: The ​ease and speed ​with which an asset can be turned into ​cash
3. Expected return​: Default risk, expected inflation, etc.
4. Risk​: The degree of uncertainty associated with the return

Liquidity
- Factors that affect the liquidity of a bond:
1. Whether there exists a ​secondary market​: e.g., mortgage vs stocks
2. ​Maturity​ Of The Bond Itself:10-year treasury bonds vs. treasury bills