1: The bond market (20 points)
a) What development in the interest rate in the bond market has occurred when the “rate
of return” of a coupon bond is lower than the interest rate mentioned on the coupon
bond? Explain. (4 points)
Interest has increased. Rate of return is yield and capital gain/loss. Because of
increased interest rate in the market the existing bonds become less attractive and
their value decreases capital loss.
b) Copy this figure to your answer sheet. Please show graphically in this figure what the
effect will be of an increase in the risk of this bond relative to the risk of other assets.
Also explain the effect (of this increase in risk) on demand, price and interest. (4 points)
Demand will shift to left because of more risk. Therefore new equilibrium with lower
price and therefore higher interest (inverse)
c) Copy this figure to your answer sheet again. Please show graphically, using this figure,
what the effect will be of an increase in expected inflation. Also explain the effect (of
this increase in expected inflation) on demand, supply, price and interest. (5 points)
Increase in expected inflation leads to lower real interest rates on existing bonds.
More attractive to borrow, less attractive to loan out. More supply and less demand.
Leads to lower price and therefore higher interest.
d) In the “Liquidity preference framework” as developed by Keynes, it is assumed that
wealth can be stored in money or in bonds. Explain the role of interest in the choice
between these two alternatives. (3 points)
Wealth can be stored in either bonds or money. Money is liquid but yields no
interest. Bonds yield interest but are less liquid. The higer the interest, the higher the
opportunity costs of holding money and vice versa.
1
, e) Suppose the yield curve for a certain bond is flat. What are the expectations about
future short-term interest rates if we assume the “Liquidity premium framework” to
hold? Explain. (4 points)
Liquidity premium theory states that long term interest rates are based upon
expected future short term interest rates plus a liquidity premium. If yield curve is
flat, long term interest is equal to short term interest. Only possible if future short-
term interest rates are expected to decline because it also consists of liquidity
premium.
2
a) What development in the interest rate in the bond market has occurred when the “rate
of return” of a coupon bond is lower than the interest rate mentioned on the coupon
bond? Explain. (4 points)
Interest has increased. Rate of return is yield and capital gain/loss. Because of
increased interest rate in the market the existing bonds become less attractive and
their value decreases capital loss.
b) Copy this figure to your answer sheet. Please show graphically in this figure what the
effect will be of an increase in the risk of this bond relative to the risk of other assets.
Also explain the effect (of this increase in risk) on demand, price and interest. (4 points)
Demand will shift to left because of more risk. Therefore new equilibrium with lower
price and therefore higher interest (inverse)
c) Copy this figure to your answer sheet again. Please show graphically, using this figure,
what the effect will be of an increase in expected inflation. Also explain the effect (of
this increase in expected inflation) on demand, supply, price and interest. (5 points)
Increase in expected inflation leads to lower real interest rates on existing bonds.
More attractive to borrow, less attractive to loan out. More supply and less demand.
Leads to lower price and therefore higher interest.
d) In the “Liquidity preference framework” as developed by Keynes, it is assumed that
wealth can be stored in money or in bonds. Explain the role of interest in the choice
between these two alternatives. (3 points)
Wealth can be stored in either bonds or money. Money is liquid but yields no
interest. Bonds yield interest but are less liquid. The higer the interest, the higher the
opportunity costs of holding money and vice versa.
1
, e) Suppose the yield curve for a certain bond is flat. What are the expectations about
future short-term interest rates if we assume the “Liquidity premium framework” to
hold? Explain. (4 points)
Liquidity premium theory states that long term interest rates are based upon
expected future short term interest rates plus a liquidity premium. If yield curve is
flat, long term interest is equal to short term interest. Only possible if future short-
term interest rates are expected to decline because it also consists of liquidity
premium.
2
