Macroeconomics

‭Current market price of the bond: $1,100‬

‭Current yield = ($50/$1,100) x 100% ≈ (0.0454) x 100% ≈ 4.54%‬

‭So,‬ ‭the‬ ‭current‬ ‭yield‬ ‭for‬ ‭this‬ ‭bond‬ ‭is‬ ‭around‬ ‭4.54%.‬ ‭This‬ ‭means‬ ‭that,‬ ‭at‬ ‭the‬ ‭current‬ ‭market‬ ‭price‬ ‭of‬ ‭$1,100, the bond is providing a 4.54% annual return based on its $50 coupon payment.‬ ‭Now that we understand the meaning of a bond’s yield, let’s analyze the relationship between interest‬ ‭rates and bond prices.‬ ‭When‬‭market‬‭interest‬‭rates‬‭go‬‭up,‬‭bond‬‭prices‬‭go‬‭down:‬‭When‬‭the‬‭prevailing‬‭market‬‭interest‬‭rates‬‭(e.g.,‬ ‭3%)‬‭rise‬‭above‬‭the‬‭fxed‬‭coupon‬‭rate‬‭of‬‭an‬‭existing‬‭bond‬‭(e.g.,‬‭2%),‬‭that‬‭bond‬‭becomes‬‭less‬‭attractive‬‭to‬ ‭investors‬‭because‬‭they‬‭can‬‭obtain‬‭higher‬‭yields‬ ‭from‬‭newly‬‭issued‬‭bonds‬ ‭.‬‭As‬‭a‬‭result,‬‭the‬‭demand‬‭for‬ ‭existing‬ ‭bonds‬ ‭with‬ ‭lower‬ ‭coupon‬ ‭rates‬ ‭decreases,‬ ‭causing‬ ‭their‬ ‭prices‬ ‭to‬ ‭fall‬ ‭to‬ ‭a‬ ‭level‬ ‭where‬ ‭their‬ ‭yields are more competitive with the higher market rates.‬ ‭When‬ ‭market‬ ‭interest‬ ‭rates‬ ‭go‬ ‭down,‬ ‭bond‬ ‭prices‬‭go‬‭up:‬‭Conversely,‬‭when‬‭market‬‭interest‬‭rates‬‭(e.g.,‬ ‭2%)‬‭fall‬‭below‬‭the‬‭fxed‬‭coupon‬‭rate‬‭of‬‭an‬‭existing‬‭bond‬‭(e.g.,‬‭3%),‬‭that‬‭bond‬‭becomes‬‭more‬‭appealing‬ ‭because‬‭its‬‭fxed‬‭interest‬‭payments‬‭represent‬‭a‬‭relatively‬‭higher‬‭yield‬ ‭compared‬‭to‬‭newly‬‭issued‬‭bonds‬ ‭with‬ ‭lower‬ ‭coupon‬ ‭rates.‬ ‭This‬ ‭increased‬ ‭demand‬ ‭for‬ ‭existing‬ ‭bonds‬ ‭pushes‬ ‭their‬ ‭prices‬ ‭higher‬ ‭as‬ ‭investors are willing to pay a premium to secure higher yields in a low-interest-rate environment.‬ ‭Understanding‬‭this‬‭relationship‬‭is‬‭essential‬‭for‬‭bond‬‭investors‬‭and‬‭portfolio‬‭managers,‬‭as‬‭it‬‭helps‬‭them‬ ‭assess‬ ‭the‬ ‭impact‬ ‭of‬ ‭interest‬ ‭rate‬ ‭movements‬ ‭on‬‭the‬‭value‬‭of‬‭their‬‭bond‬‭holdings‬‭and‬‭make‬‭informed‬ ‭investment decisions.‬ ‭B. Time Value of Money (Present and Future Value)‬ ‭One‬‭of‬‭the‬‭most‬‭important‬‭concepts‬‭in‬‭fnance‬‭is‬‭the‬ ‭present‬‭value‬ ‭of‬‭money.‬‭Consider‬‭a‬‭choice:‬‭either‬ ‭taking‬ ‭$100‬ ‭today‬ ‭or‬ ‭waiting‬ ‭for‬ ‭two‬ ‭years‬ ‭to‬ ‭receive‬ ‭$220‬ ‭instead.‬ ‭Which‬ ‭option‬ ‭is‬ ‭best‬ ‭and‬ ‭why?‬ ‭Calculating‬‭the‬‭present‬‭value‬‭allows‬‭us‬‭to‬‭determine‬‭the‬ ‭current‬‭value‬ ‭of‬‭the‬‭$220‬‭that‬‭will‬‭be‬‭received‬ ‭in two years (i.e., its value today), helping to answer this question.‬ ‭PV =‬ (‭1‬‭‭‬+‭‬‭‬ ‬)‭ⁿ‬ ‭Whereby:‬ ‭●‬ ‭“PV” is the present value of money‬ ‭●‬ ‭“FV” is the future value of money ($220 in the previous example)‬ ‭●‬ ‭“i”‬‭refers‬‭to‬‭the‬‭real‬‭interest‬‭rate‬ ‭(recall‬‭from‬‭Chapter‬‭2‬‭Section‬‭C:‬‭Nominal‬‭and‬‭Real‬‭Values,‬‭that‬ ‭real‬‭value‬‭=‬‭nominal‬‭value‬‭−‬‭inflation‬‭rate‬‭→‬‭real‬‭interest‬‭rate‬‭=‬‭nominal‬‭interest‬‭rate‬‭−‬‭inflation‬ ‭rate)‬ ‭●‬ ‭“n” refers to the number of years (2 in the previous example)‬

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