Understanding Expected Return And Shifts In The Demand And Supply Curve Of Zero Coupon Bonds Essay.

1.If the market equilibrium of this bond has a return of 20% what is the current market price? Justify your (Hint: Use the same expected return equation, solve for P.)

2. Discuss four (4) factors that would cause the demand curve and four (4) factors that would cause the supply curve for bonds to shift? Illustrate your answer  

Overall Return and Demand for Zero-Coupon Bond

The above table mainly depicts the overall return, which is been provided by zero-coupon bond whose market price is $800. In addition, the face value of the bond is $1000, whereas market price is $800, which could help investors in attaining a return of 25%. Moreover, the evaluation of 25% return from investment could mainly increase the overall demand for the bond among potential investors. Zhang (2016) stated that investors mainly use ratings from independent agencies for determining the overall return, which could be provided from bonds. The expected return depicted in above table could mainly help in generating riskless return to the investor.

The bond with market price of $950 will mainly provide an expected return of 5.26%, which is due to the reduced difference between face value and market value of the bond. However, investment in zero coupon bonds could mainly help in generating the required return at the bonds tenure. On the other hand, Cifuentes (2016) argued that bonds mainly lose its friction if the inflation rate rises, which nullifies the excess return generated from investment. Moreover, the investor will be interested in buying bonds at the value of $950, as it could help in generating a profit of $50 at the end of bond tenure.

The above table mainly depicts that both market price and face value of the bond is at same level $1000, which could make the expected return to 0%. This zero return from investment could mainly reduce the overall interest of the investors in investing in the zero coupon bond. Chang and Ross (2016) mentioned that zero coupon bonds are mainly chosen if the inflation rate is expected to be negative in future.

Moreover, the overall expected return from the above-depicted table is negative 20%, as market price is higher than the face value of the bond. This mainly initiates a loss in investment if investors opt for purchasing the zero coupon bond. The bond does not provide any kind of return in form on coupons, which could nullify the investment conducted in zero coupon bonds. Qin and Linetsky (2016) mentioned that derivation of expected return is mainly essential for investor to identify the overall return, which could be generated from the bond.

The overall market price of the bond is mainly identified at $833.33 with an expected return of 20%, which could be provided by the zero coupon bond. Moreover, the market equilibrium of the bond mainly helps investor in identifying the actual market price, which could maximise the return from investment. However, any decline in market price could only increase the demand for the bond, while prices increasing more than $833.33 could reduce its overall demand. Barnard (2017) argued that bond valuation and return derivation is mainly conducted by accommodating inflation rate, which depicts the present value of the future returns.

Impact of Market Price and Face Value on Bond Valuation

The overall bond prices are mainly affected by both supply and demand conditions portrayed in the market. Furthermore, several factors could be identified, which might affect the overall prices of bond due to the change on both supply and demand. Greenwood, Hanson and Vayanos (2015) stated that shift in the overall supply and demand curve is mainly conducted due to certain external market conditions.

Demand of bonds mainly increases if the investors could witness the overall demise in interest rate. Furthermore, if the interest rate decreases than bonds returns then investor mainly opt for increasing the exposure in bonds. This mainly helps in increasing short-term rise in demand for bonds, which in turn shifts the demand curve to right. However, interest rate also increase, which will have a negative impact on demand and shift the demand curve of bond to left (Jylha, Rinne and Suominen 2014).

Moreover, if investors are able to generate higher income and wealth from investment then investors search adequate investment opportunity. The wealth accumulated by investors could mainly be reinvested in bonds, which in turn could raise the demand of bonds. This increment in the overall demand of bonds could main help in shifting the demand curve of the bond. However, negative demand of bonds mainly occurs during an economic crisis where investor’s investment capital is hindered. This decline in wealth negatively affects the demand curve of bond, as contraction in demand could be seen (Bacchetta and Benhima 2015).

The overall decline in inflation rate could also help in generating demand for bonds, as investor mainly opt for investment options, which provides increased return without any risk. The decline in inflation rate could mainly reduce the return, which is been provided from interest payments. This decline in inflation rate mainly helps in improving demand for bonds, whose increased return could lure in more investors. This rise in overall demand could mainly shift the demand curve to right (Harford and Uysal 2014).

Furthermore, investors mainly need high liquidity in the overall bond market for effectively conducting the relative trades. Thus, increment in the liquidity could effectively increase the overall trades of the bond, which in turn could raise demand among potential investors. This rising demand could shift the demand curve of the bond (Santos 2014).

The overall shift in demand curve of the bond, which is mainly conducted by the factors depicted above. The rise in overall demand of bond could mainly shift the demand curve and raise its equilibrium price, while supply remains constant. Yunpeng and Baochen (2015) mentioned that increment in demand while supply being constant mainly inflates prices of the product.

Factors Affecting the Demand and Supply Curve of Bond

Overall decline in corporate tax could mainly allow companies to generate higher retained profits from operations. This could instigate corporations to raise debt from bonds, which could improve its overall operations and revenue. Moreover, increment in bond issue could shift the overall supply curve of the bond, which in turn could reflect on its overall valuation (Bekaert et al. 2016).

Furthermore, increment in the overall government expenditure could mainly raise its deficit, which is supported by issuing new bonds that expands the supply curve. Increment in overall government expenditure could mainly raise the debt accumulated in form of debt. Chang and Ross (2016) argued that reduced return from bonds could mainly decline the overall demand and increase supply of bond. The rise in bond issue could mainly shift the supply curve of bond, where demand curve remains constant.

The increment in inflation rate could also instigate and motivate organisation to issue bonds at low rate. Moreover increase in inflation rate could also help organisation to reduce the value of capital, which is been taken as debt from the market. This method allows organisation to utilise the impact of inflation and increase supply of the overall bonds. This increment in supply of bonds mainly shifts the supply curve, while demand curve remains constant (Qin and Linetsky 2016).

Furthermore, if the overall expected net profits of the organisation increase then the corporations tends to add more debt, which could help in improving their ability to generate higher revenue. In addition, corporation mainly evaluates projects and new scope, which could help in improving their ability to raise its net income. Thus, organisations issue new bonds in form of debt to raise the required capital for supporting their expansion process. This increment in the overall supply of bonds mainly raises the supply curve (Greenwood, Hanson and Vayanos 2015). 

It helps in depicting the overall shift in supply curve of the bond, while demand curve remains constant. In addition, the above-mentioned factors mainly help in shifting supply curve of bond, which in turn decrease value of the bond. Bacchetta and Benhima (2015) argued that increase in overall supply mainly pulls down the prices, which negatively affects value of the bond.

Reference:

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Bekaert, G., Harvey, C.R., Lundblad, C.T. and Siegel, S., 2016. Political risk and international valuation. Journal of Corporate Finance, 37, pp.1-23.

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Greenwood, R., Hanson, S. and Vayanos, D., 2015. Forward guidance in the yield curve: short rates versus bond supply (No. w21750). National Bureau of Economic Research.

Harford, J. and Uysal, V.B., 2014. Bond market access and investment. Journal of Financial Economics, 112(2), pp.147-163.

Jylhä, P., Rinne, K. and Suominen, M., 2014. Do Hedge Funds Supply or Demand Liquidity?. Review of Finance, 18(4), pp.1259-1298.

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