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Chapter 5: Q.6 (page 164)

Raphael observes that at the current level of interest rates there is an excess supply of bonds, and therefore he anticipates an increase in the price of bonds. Is Raphael correct?

Short Answer

Expert verified

An excess supply of bonds in the market will lower the bond's price.

Step by step solution

01

Introduction

The amount demanded of an asset is directly related to wealth, expected return on asset, and liquidity of the asset, and negatively proportional to expected return on alternative asset, liquidity of the alternative asset, according to the theory of portfolio choice.

02

Explanation

R made the observation that the supply of bonds has increased at the current level of interest rates, implying an increase in bond prices. R's prediction of a rise in bond prices is incorrect since it is based on the assumption that bond prices will rise owing to reduced interest rates and the market's supply of bonds will expand. However, according to portfolio theory, an excess supply of bonds in the market will lower the bond's price.

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Most popular questions from this chapter

Explain why you would be more or less willing to buy long-term Delta Air Lines bonds under the following circumstances:

a. The company just released its financial statements, indicating that income decreased and liabilities increased.

b. You expect a bull market in stocks (stock prices are expected to increase).

c. You have analyzed your country’s monetary policy and expect interest rates to decrease.

d. Brokerage commissions on bonds fall.

e. Your income and wealth increased over the last two years.

Suppose Maria prefers to buy a bond with a 7% expected return and 2% standard deviation of its expected return, while Jennifer prefers to buy a bond with a 4% expected return and 1% standard deviation of its expected return. Can you tell if Maria is more or less risk-averse than Jennifer?

What will happen in the bond market if the government imposes a limit on the amount of daily transactions? Which characteristic of an asset would be affected?

Suppose you visit with a financial adviser, and you are considering investing some of your wealth in one of three investment portfolios: stocks, bonds, or commodities. Your financial adviser provides you with the following table, which gives the probabilities of possible returns from each investment.

a. Which investment should you choose to maximize your expected return: stocks, bonds, or commodities?

b. If you are risk-averse and had to choose between the stock and the bond investments, which would you choose? Why?

One of the points made in this chapter is that inflation erodes investment returns. Go to http://www.moneychimp.com/articles/econ/inflation_calculator.htm and review how changes in inflation alter your real return using the second inflation calculator. What happens to the difference between the future value of an investment and its inflation-adjusted value as

a. inflation increases?

b. the investment horizon lengthens?

c. expected returns increase?
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