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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

The demand curve and supply curve for one-year discount bonds with a face value of $1050are represented by the following equations:Bd:Price=-0.8×Quantity+1160Bs:Price=Quantity+720Suppose that, as a result of monetary policy actions, the Federal Reserve sells 90 bonds that it holds. Assume that bond demand and money demand are held constant.

a. How does the Federal Reserve policy affect the bond supply equation? b. Calculate the effect on the equilibrium interest rate in this market, as a result of the Federal Reserve action.

If the next chair of the Federal Reserve Board has a reputation for advocating an even slower rate of money growth than the current chair, what will happen to interest rates? Discuss the possible resulting situations.

An important way in which the Federal Reserve decreases the money supply is by selling bonds to the public. Using a supply and demand analysis for bonds, show what effect this action has on interest rates. Is your answer consistent with what you would expect to find with the liquidity preference framework?

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?

Suppose you are in charge of the financial department of your company and you have to decide whether to borrow short or long term. Checking the news, you realize that the government is about to engage in a major infrastructure plan in the near future. Predict what will happen to interest rates. Will you advise borrowing short or long term?
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