On the basis of Problem 16-1, imagine that initially the market interest rate is 5 per cent and at this interest rate you have decided to hold half of your financial wealth like bonds and half as holdings of non-interest-bearing money. You notice that the market interest rate is starting to rise, however, and you become convinced that it will ultimately rise to 10 per cent.

a. In what direction do you expect the value of your bond holdings to go when the interest rate rises?

b. If you wish to prevent the value of your financial wealth from declining in the future, how should you adjust the way you split your wealth between bonds and money? What does this imply about the demand for money?

Step by step solution

01

introduction 

A non-maturing bond is a non-redeemable bond with no development date. These bonds are treated as value, not obligation and pay a constant flow of interest instalments for eternity.

02

explanation part (a)

We know,

Net income of bond = I

nominal rate = r

$P{}_o=\frac{I}{r}$

At r = $0.05$

$P_o=\frac{I}{0.05}$

At r = $0.10$

$P_0=\frac{I}{0.10}$

The value of your bond holdings to go when the interest rate rises will fall with rising discount rates.

03

explanation part (b)

As the discount rate increases the current worth of the security falls. In the event that you need the current worth of your monetary abundance from declining in future, you would incline toward non-premium yielding money to securities. Your growth strategy would incorporate less abundance in unendingness and a rising part in money.

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