Questions
1. Bond Investment Decision. Based on your forecast of interest rates, would you recommend that
investors purchase bonds today? Explain.
ANSWER: Students that expect interest rates to rise should expect bond prices to decline in the
future, and therefore not recommend that investors purchase bonds today. Conversely, students that
2. How Interest Rates Affect Bond Prices. Explain the impact of a decline in interest rates on:
a. An investor’s required rate of return.
b. The present value of existing bonds.
c. The prices of existing bonds.
3. Relevance of Bond Price Movements. Why is the relationship between interest rates and bond prices
important to financial institutions?
ANSWER: Most financial institutions maintain a portfolio of bonds or mortgages that provide fixed
4. Source of Bond Price Movements. Determine the direction of bond prices over the last year and
explain the reason for it.
ANSWER: If prices of existing bonds have increased, this is normally because interest rates have
5. Exposure to Bond Price Movements. How would a financial institution with a large bond portfolio
be affected by falling interest rates? Would it be affected more than a financial institution with a
greater concentration of bonds (and fewer short-term securities)? Explain.
ANSWER: The market value of the financial institution’s bond portfolio will increase. A financial
6. Comparison of Bonds to Mortgages. Since fixed-rate mortgages and bonds have similar payment
flows, how is a financial institution with a large portfolio of fixed-rate mortgages affected by rising
interest rates? Explain.
7. Coupon Rates. If a bond’s coupon rate were above its required rate of return, would its price be
above or below its par value? Explain.
8. Bond Price Sensitivity. Is the price of a long-term bond more or less sensitive to a change in interest
rates than to the price of a short-term security? Why?
ANSWER: The price of a long-term bond is more sensitive to a given change in interest rates than the
price of a short-term security. The long-term bond provides fixed payments for a longer period of
9. Required Return on Bonds. Why does the required rate of return for a particular bond change over
time?
10. Inflation Effects. Assume that inflation is expected to decline in the near future. How could this
affect future bond prices? Would you recommend that financial institutions increase or decrease their
concentration in long-term bonds based on this expectation? Explain.
ANSWER: Since lower inflation normally causes a decline in interest rates (other things being equal),
11. Bond Price Elasticity. Explain the concept of bond price elasticity. Would bond price elasticity
suggest a higher price sensitivity for zero-coupon bonds or high-coupon bonds that are offering the
same yield to maturity? Why? What does this suggest about the market value volatility of mutual
funds containing zero-coupon Treasury bonds versus high-coupon Treasury bonds?
ANSWER: Bond price elasticity measures the percentage change in a bond’s price in response to a
percentage change in interest rates. The percentage change in the price (as measured by present value)
12. Economic Effects on Bond Prices. An analyst recently suggested that there will be a major
economic expansion that will favorably affect the prices of high-rated fixed-rate bonds, because the
credit risk of bonds will decline as corporations improve their performance. Assuming that the
economic expansion occurs, do you agree with the conclusion of the analyst? Explain.
ANSWER: The decline in the credit risk will result in slightly lower bond premiums, which would
13. Impact of War. When tensions rise or war erupts in the Middle East, bond prices in many countries
tend to decline. What is the link between problems in the Middle East and bond prices? Would you
expect bond prices to decline more in Japan or in the United Kingdom as a result of the crisis? (The
answer is tied to how interest rates may change in those countries.) Explain.
ANSWER: The crisis led to an anticipated shortage of oil, which can fuel inflation. Those countries
14. Bond Price Sensitivity. Explain how bond prices may be affected by money supply growth, oil
prices, and economic growth.
ANSWER: Any factors that affect inflationary expectations may affect interest rate expectations and
therefore affect the demand for bonds. Higher oil prices, excessive money supply growth, and strong
15. Impact of Oil Prices. Assume that oil-producing countries have agreed to reduce their oil production
by 30 percent. How would bond prices be affected by this announcement? Explain.
ANSWER: Reduced oil production implies higher oil prices, higher interest rates, and lower bond
16. Impact of Economic Conditions. Assume that breaking news causes bond portfolio managers to
suddenly expect much higher economic growth. How might bond prices be affected by this
expectation? Explain. Now assume that breaking news causes bond portfolio managers to suddenly
anticipate a recession. How might bond prices be affected? Explain.
ANSWER: Higher economic growth places upward pressure on interest rates and downward pressure
A recession tends to imply a reduced demand for loanable funds and therefore lower interest rates and
Advanced Questions
17. Impact of the Fed. Assume that the bond market participants suddenly expect the Fed to
substantially increase the money supply.
a. Assuming no threat of inflation, how would bond prices be affected by this expectation?
ANSWER: Without the threat of inflation, an increase in the money supply could reduce interest rates
b. Assuming that inflation may result, how would bond prices be affected?
ANSWER: If inflation increases, interest rates will likely increase, and prices of existing bonds will
c. Given your answers to (a) and (b), explain why expectations of the Fed’s increase in the money
supply may sometimes cause bond market participants to disagree about how bond prices will be
affected.
ANSWER: Some bond market participants may expect that the Fed’s actions will cause higher
18. Impact of the Trade Deficit. Bond portfolio managers closely monitor the trade deficit figures,
because the trade deficit can affect exchange rates, which can affect inflationary expectations and
therefore interest rates.
a. When the trade deficit figure is higher than anticipated, bond prices typically decline. Explain
why this reaction may occur.
ANSWER: A higher trade deficit figure signals the possibility of continued high trade deficits, which
b. On some occasions, the trade deficit figure has been very large, but the bond markets did not
respond to the announcement. Assuming that no other information offset the impact, explain why
the bond markets may not have responded to the announcement.
ANSWER: If the large trade deficit was already anticipated by the market, the announcement does
19. International Bonds. A U.S. insurance company purchased British 20-year Treasury bonds instead of
U.S. 20-year Treasury bonds because the coupon rate was 2 percent higher on the British bonds.
Assume that the insurance company sold the bonds after five years. Its yield over the five-year period
was substantially less than the yield it would have received on the U.S. bonds over the same five-year
period. Assume that the U.S. insurance company had hedged its exchange rate exposure. Given that
the lower yield was not because of default risk or exchange rate risk, explain how the British bonds
could have generated a lower yield than the U.S. bonds. (Assume that either type of bond could have
been purchased at the par value.)
ANSWER: If British interest rates increased or remained constant while U.S. interest rates declined,
20. International Bonds. The pension fund manager of Utterback (a U.S. firm) purchased German
20-year Treasury bonds instead of U.S. 20-year Treasury bonds. The coupon rate was 2 percent lower
on the German bonds. Assume that the manager sold the bonds after five years. The yield over the
five-year period was substantially more than the yield it would have received on the U.S. bonds over
the same five-year period. Explain how the German bonds could have generated a higher yield than
the U.S. bonds for the manager, even if the exchange rate is stable over this five-year period. (Assume
that the price of either bond was initially equal to its respective par value). Be specific.
ANSWER: The German interest rates could have declined while U.S. interest rates increased, so that
the value of the German bonds was higher than the value of U.S. bonds after five years. Even if
21. Implications of a Shift in the Yield Curve. Assume that there is a sudden shift in the yield curve,
such that the new yield curve is higher and more steeply sloped today than it was yesterday. If a firm
issues new bonds today, would its bonds sell for higher or lower prices than if it had issued the bonds
yesterday? Explain.
22. How Bond Prices May Respond to Prevailing Conditions. Consider the prevailing conditions for
inflation (including oil prices), the economy, the budget deficit, and the Fed’s monetary policy that
could affect interest rates. Based on prevailing conditions, do you think bond prices will increase or
decrease during this semester? Offer some logic to support your answer. Which factor do you think
will have the biggest impact on bond prices?
ANSWER: This question is open-ended. It requires students to apply the concepts that were presented
23. Interaction Between Bond and Money Markets. Assume that you maintain bonds and money
market securities in your portfolio, and you suddenly believe that long-term interest rates will rise
substantially tomorrow (even though the market does not share the same view), while short-term
interest rates will remain the same.
a. How would you rebalance your portfolio between bonds and money market securities?
b. If the market suddenly recognizes that long-term interest rates will rise tomorrow, and that they
respond in the same manner as you, explain how the demand for these securities (bonds and
money market securities), supply of these securities for sale, and prices and yields of these
securities will be affected.
ANSWER: Bond prices will decline, while the prices of money market securities will rise as investors
c. Assume that the yield curve is flat today. Explain how the slope of the yield curve will change
tomorrow in response to the market activity.
24. Impact of the Credit Crisis on Risk Premiums. Explain how the prices of bonds were affected by
a change in the risk-free rate during the credit crisis. Explain how bond prices were affected by a
change in the credit risk premium during the credit crisis.
25. Systemic Risk. Explain why there are concerns about systemic risk in the bond and other debt
markets. Also explain how the Financial Reform Act of 2010 was intended to reduce systemic risk.
ANSWER: Systemic risk refers to the potential collapse of the entire market or financial system.
Many financial institutions rely heavily on debt to fund their operations, and they are interconnected
by financing each other’s debt positions. If some of these financial institutions cannot repay their
Interpreting Financial News
Interpret the following comments made by Wall Street analysts and portfolio managers.
a. “Given the recent uncertainty about future interest rates, investors are fleeing from zero-coupon
bonds.”
b. “Catrell Insurance Company invests heavily in bonds, and its stock price increased substantially
today in response to the Fed’s signal that it plans to reduce interest rates.”
c. “Bond markets declined when the Treasury flooded the market with its new bond offering.”
If the Treasury issues new bonds, the supply of bonds may exceed the demand, causing a decline