course hero how the supply and demand of bonds operates in the bond market.

What drives the demand for money?

The motives driving the demand for money are now represented by the supply of bonds. It's an upward-sloping line because issuers will supply more bonds when they fetch a higher price. The demand for bonds from buy-side investors slopes downward because a lower price on a fixed-coupon bond corresponds to a higher yield.

Why is the demand for bonds from buy-side investors downward sloping?

It's an upward-sloping line because issuers will supply more bonds when they fetch a higher price. The demand for bonds from buy-side investors slopes downward because a lower price on a fixed-coupon bond corresponds to a higher yield.

Does supply and demand matter in bond pricing and performance?

Their preferred-habitat construct distinguishes the aforementioned role of supply and demand from that of alternative investment opportunities in bond pricing. Implementation of the model helps the authors investigate the role of supply and demand in fixed-income pricing and performance.

What is the connection between the bond market and the economy?

The lower price for bonds means a higher interest rate. The connection between the bond market and the economy derives from the way interest rates affect aggregate demand. For example, investment is one component of aggregate demand, and interest rates affect investment.

Why are bonds the easiest to figure?

Bonds are the easiest of the two to figure, because bonds change value mostly from changing interest rates, since they are interest-bearing instruments essentially. While the supply and demand for bonds does factor into things somewhat, and if more people wanted to invest in bonds their price does rise, this rise is quite limited in potential due ...

Who decides the price of a stock?

The market decides the price of stocks, not mostly, but entirely. The only exception to this is initial public offerings, which are offered at a set price, but after the shares are issued, the market takes over completely and retains full say for the life of the stock.

What happens when the price goes up?

When the price goes up, sellers will naturally raise their asking prices, and provided that there is enough demand at this higher price, it will trade higher. The opposite happens as the price declines. This creates momentum, and is why stocks do move in discernable patterns in both directions.

What is the restraining force on stock prices?

The only real fundamental restraining force upon stock prices is the concern that some investors have if the price gets too out of line with business fundamentals, things like price to earnings ratios and such.

Do bond issuers want to borrow?

A bond issuer will only want to borrow at a certain rate, a certain amount over the LIBOR rate we’ll say, which will depend on the creditworthiness of the issuer as well as competitive forces in the debt market, which bonds are a big part of. Traders may trade these bonds among themselves, and this happens a lot, ...

What causes governments to issue bonds and hence shift the bond supply curve right?

Deficits cause governments to issue bonds and hence shift the bond supply curve right; surpluses have the opposite effect.

How does a boom affect bond prices?

If you noticed that the response of bond prices and yields to a business cycle expansion is indeterminate, booya! As noted above, a boom shifts the bond supply curve to the right by inducing businesses to borrow and thus take advantage of the bonanza. Holding demand constant, that action reduces bond prices (raises the interest rate). But demand does not stay constant because economic expansion increases wealth, which increases demand for bonds (shifts the curve to the right), which in turn increases bond prices (reduces the interest rate). The net effect on the interest rate, therefore, depends on how much each curve shifts, as in Figure 5.9 "Business cycle expansion and bond prices".

Why does demand not stay constant?

But demand does not stay constant because economic expansion increases wealth, which increases demand for bonds (shifts the curve to the right), which in turn increases bond prices (reduces the interest rate). The net effect on the interest rate, therefore, depends ...

Why does the demand curve shift?

The demand curve for bonds shifts due to changes in wealth, expected relative returns, risk, and liquidity. Wealth, returns, and liquidity are positively related to demand; risk is inversely related to demand. Wealth sets the general level of demand. Investors then trade off risk for returns and liquidity.

Does the bond supply curve shift?

Empirically, the bond supply curve typically shifts much further than the bond demand curve, so the interest rate usually rises during expansions and always falls during recessions.

Which scenario usually wins out?

In reality, the first scenario is the one that usually wins out: during expansions, the interest rate usually rises, and during recessions, it always falls. For example, the interest rate fell to very low levels during the Great Depression (an almost worldwide downturn in economic output in the early 1930s) and during Japan’s extended economic funk (period of low to no increase in per capita incomes) in the 1990s. www.bloomberg.com/apps/news?pid=10000101&refer=japan&sid=a28sELjm9W04

Does expected inflation increase bond yields?

If you’ve already figured out that expected inflation will decrease bond prices, and increase bond yields, by both shifting the supply curve to the right and the demand curve to the left, as in Figure 5.8 "Expected inflation and bond prices" , kudos to you!

When an institution sells a bond, it obtains the price paid for the bond as a kind of answer?

When an institution sells a bond, it obtains the price paid for the bond as a kind of loan . The institution that issues the bond is obligated to make payments on the bond in the future. The interest rate is determined by the price of the bond. To understand these relationships, let us look more closely at bond prices and interest rates.

How does bond market affect aggregate demand?

The connection between the bond market and the economy derives from the way interest rates affect aggregate demand. For example, investment is one component of aggregate demand, and interest rates affect investment. Firms are less likely to acquire new capital (that is, plant and equipment) if interest rates are high; they’re more likely to add capital if interest rates are low 1.

What happens when the demand for bonds increases to D2?

An increase in the demand for bonds to D2 in Panel (a) raises the price of bonds to Pb2, which lowers interest rates and boosts investment. That increases aggregate demand to AD2 in Panel (b); real GDP rises to Y2 and the price level rises to P2.

What happens to bond prices when interest rates go up?

If bond prices fall, interest rates go up. Higher interest rates tend to discourage investment, so aggregate demand will fall. A fall in aggregate demand, other things unchanged, will mean fewer jobs and less total output than would have been the case with lower rates of interest. In contrast, an increase in the price of bonds lowers interest rates and makes investment in new capital more attractive. That change may boost investment and thus boost aggregate demand.

How do bonds change price?

Bond prices are perfectly flexible in that they change immediately to balance demand and supply. Suppose, for example, that the initial price of bonds is $950, as shown by the intersection of the demand and supply curves in Figure 25.1 “The Bond Market”. We will assume that all bonds have equal risk and a face value of $1,000 and that they mature in one year. Now suppose that borrowers increase their borrowing by offering to sell more bonds at every interest rate. This increases the supply of bonds: the supply curve shifts to the right from S1 to S2. That, in turn, lowers the equilibrium price of bonds—to $900 in Figure 25.1 “The Bond Market”. The lower price for bonds means a higher interest rate.

How long does it take for a bond to mature?

The maturity date might be three months from the date of issue; it might be 30 years. Whatever the period until it matures, and whatever the face value of the bond may be, its issuer will attempt to sell the bond at the highest possible price. Buyers of bonds will seek the lowest prices they can obtain.

How long does a bond last?

They have a face value (usually an amount between $1,000 and $100,000) and a maturity date. The maturity date might be three months from the date of issue; it might be 30 years.

How do market economies work?

That's how market economies are supposed to work – at least when there are no government price controls or other impediments to the free flow of goods and services. The market-clearing price will be such that demand equals supply, that is, where the two curves cross in the classic economics diagram. We'll soon use those diagrams to determine the level of bond prices and yields.

What is the horizontal axis of the demand curve?

The horizontal axis is the quantity of money; the vertical axis is the price of money (i.e., the interest rate). The bond issuers need money, so they constitute the demand curve. The curve is downward sloping because the lower the cost of borrowed funds, the more money they want. To be more technical, we could appeal to corporate finance theory ...

What is the expected inflation rate if the nominal rate stays at 4.2%?

If the nominal interest rate stays at 4.2%, the expected real rate of interest goes up from about 2.2% to 3.2% – that's good for lenders, but bad for borrowers. That statement uses the standard decomposition of a nominal interest rate into the expected real rate and the expected inflation rate.

What does interest rate mean in bond math?

Sometimes “interest rate” stands for the level of market interest rates for some degree of credit risk and time to maturity. Because the graph plots money demand and supply, “interest rate” is the most natural term here, although we could use “bond yield” as well.

Should nominal rates include compensation for the expected real rate of return?

Their idea is that the nominal rate should include compensation for the expected real rate of return and inflation as well as uncertainty about those expectations.

What is the purpose of standard models of the term structure of interest rates?

Standard models of the term structure of interest rates assume perfect markets . The authors’ research takes into account the effects of supply and demand on bond performance with the goal of providing a tool to enable better fixed-income portfolio performance. Their preferred-habitat construct distinguishes the aforementioned role of supply and demand from that of alternative investment opportunities in bond pricing. Implementation of the model helps the authors investigate the role of supply and demand in fixed-income pricing and performance.

How Did the Authors Conduct This Research?

Reviewing the limited literature on the subject of the effect of interest rate term structures on the demand for bonds, the authors develop an affine preferred-habitat term structure model that assumes the presence of (1) preferred-habitat investors that trade bonds with specific maturities that satisfy specific time horizons and (2) arbitrageurs that invest in bonds of varying maturities with the objective of mitigating risk. They then refine the model by introducing state variables and the explanatory effects of the role of preferred habitat and arbitrage on bond demand and pricing. They apply the model to the burgeoning bond market in China, a rich dataset that is increasingly in the sights of fixed-income portfolio managers.

Does demand from preferred-habitat investors negatively affect bond yields?

Applying their model in this context, the authors illustrate that yields on alternative investment opportunities benefit bond yields, whereas demand from preferred-habitat investors and arbitrageurs negatively affects bond yields.