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Questions:

1.What is the Expected return for this bond If the Market Price is:
     a.$800?
     b.$950?
     c.$1000
     d.$1250

2.If the Market Equilibrium of this bond has a return of 20% what is the Current Market Price? Justify your result.

3.Discuss Four Factors that would Cause the Demand Curve and Four Factors that would Cause the Supply Curve for bonds to Shift?
 
 

Answers:

1. Depicting the expected return of zero coupon bonds with different market rate:

a. Expected return when market price is $800:

Particulars

Value

Expected return

((FV / Current Price) -1 ) * 100

Expected return

((1000 / 800) -1 ) * 100

Expected return

(1.25 -1 ) * 100

Expected return

.25 * 100

Expected return

25%

The overall return generated from zero coupon bonds with the market price of $800 is 25%, as the FV is $1000. The return is mainly derived from market price, which is lower than the actual face value. This reduced market price of the bond could mainly help the investor in generating higher return from investment (Ballotta and Kyriakou 2015). Market price at $800 could effectively help the investor get the maximum return from investment in comparison from other market price. The investor will be interested in buying the bond at $800 value.

b. Expected return when market price is $950:

Particulars

Value

Expected return

((FV / Current Price) -1 ) * 100

Expected return

((1000 / 950) -1 ) * 100

Expected return

(1.05 -1 ) * 100

Expected return

.05 * 100

Expected return

5.26%

If the market price of the zero coupon bond is $950 then the expected return mainly declines from previous value. This is due to the lower difference between face value and market value of the bond. The return of 5.26% is also effective as investor will be able to generate retune from investment at the end of the bond tenure. Di and Rosadi (2015) mentioned that investors are mainly attracted to bonds, which are provided at a discounted rate, as it help in generating high return from investment. The investor will be interest in investment if the bond price is $950.

c. Expected return when market price is $1000:

Particulars

Value

Expected return

((FV / Current Price) -1 ) * 100

Expected return

((1000 / 1000) -1 ) * 100

Expected return

(1 -1 ) * 100

Expected return

0 * 100

Expected return

0%

The market value being same as face value, as depicted in above table could mainly nullify any return, which could be provided from zero coupon bonds. There is no expected return if the market price is at $1000, thus the investor will not be interested in conducting the relative investment. Brockington et al. (2014) argued that investors mainly neglect the deals, which does not provide relative return from investment. Thus, the investor could neglect the zero coupon bond as no return is provided from investment.

d. Expected return when market price is $1250:

Particulars

Value

Expected return

((FV / Current Price) -1 ) * 100

Expected return

((1000 / 1250) -1 ) * 100

Expected return

(0.8 -1 ) * 100

Expected return

-0.20 * 100

Expected return

-20%

 The above table mainly depicts a negative return or loss, which might incur by the investor if investment is been conducted. In addition, the loss of -20% will mainly incur by the investor as the market price is more than the face value, which will be provided after completion of the bond tenure. Maximum of the investors will mainly avoid zero coupon bonds, whose   market value is greater than the face value (Bielecki and Rutkowski 2013).

2.Depicting the current market price if the market equilibrium of this bond has a return of 20%:

Particulars

Value

Market price

FV / (Expected return + 1)

Market price

1000 / (0.20 + 1)

Market price

1000 / 1.20

Market price

833.33

The above table mainly depicts the overall market price of the bond if the return is anticipated at 20%. In addition, after the valuation of expected return overall market price is mainly depicted at $833.33. Any increment in the overall market price of the bond could mainly reduce the demand among potential investor and decrease its price. Furthermore, it is a zero coupon bond, where return could only be provided at the end of bond tenure (Badertschere et al. 2015). Thus, if the bond price declines more from 833.33 then the investor will be interested in buying the bond.

3. Discussing the four factors that might cause demand curve and supply curve of the bond to shift:

Bond prices mainly reflect on both supply and demand, which could help investors in making adequate investment decision. There are several factors, which could shift the overall demand and supply curve of bond. Greenwood and Vayanos (2014) mentioned that change in demand and supply of bond mainly helps investor making adequate investment decision.

Four factors that might cause demand curve of bond to shift:


Figure 1: Depicting the shift in demand curve of Bond

(Source: Greenwood and Vayanos 2014)

 The figure mainly depicts the relevant shift in demand curve of bond, which changes the market equilibrium. The factors depicted mainly shifts the supply curve from D to D` keeping the supply constant. Four factors that might cause demand curve of bond to shift are depicted as follows.

Increase in investor’s wealth:

Increment in the overall investor’s wealth could mainly help in raising its investment ability. The growing economy mainly helps in increasing wealth, which could raise ability of the investors to buy more bonds. This increment in the overall demand of bond could shift the demand curve while keeping the supply curve constant. Becker and Ivashina (2014) mentioned that increment in bond demand could mainly help companies and governments to generate higher capital from bond issue.

Decrease in interest rates:

Decline in overall interest rates of banks could mainly increase the overall demand for bonds. In addition, bond return is mainly fixed while interest rate varies, which makes bond an attractive investment opportunity of interest rate decline. The demand for bonds mainly increases with the decline in demand for interest rate. The sudden decline in interest rate mainly helps in shifting the demand curve of the bond (Wang, Weiz and Zhong 2015).

 

Increase in liquidity position of the bonds:

Bond market has low liquidity as investors mainly use bonds as fixed investment. However, investor are mainly attracted to bond, which have high liquidity, as they are able to conduct both sell and buy functions frequently. If the bond market is liquid as US government a securities then overall demand of bond rises. This increment in demand of bonds mainly helps in shifting its demand curve. Brissimis, Garganas and Hall (2014) argued that demand curve of bond could be shifted on either way, which states the contraction and increment of demand among investors.

Decrease in expected inflation:

 Furthermore, the overall decline in expected inflation rate mainly increases the benefits, which is been provided by the bonds. This mainly helps in raising the overall demand and shifts demand curve of the bond. The future return on every bond is mainly discounted to identify the present value, which incorporates inflation rate. Thus, the decline in inflation rate mainly increases the overall return, which could be provided by the bond. Mina, Lahr and Hughes (2013) mentioned that returns from bonds mainly increase in value if inflation rate declines, which makes the opportunity a riskless investment.

Four factors that might cause supply curve of bond to shift:

Figure 2: Depicting the shift in supply curve of Bond

(Source: Greenwood and Vayanos 2014)

The figure mainly depicts the relevant shift in supply curve of bond, which changes the market equilibrium. The factors depicted mainly shifts the supply curve from S to S` keeping the supply constant. Four factors that might cause supply curve of bond to shift are depicted as follows.

Rise in expected profits:

The overall supply of bond mainly increases if organisation expects profit growth by implementing high-end investment. The overall rise in expected profits mainly allow organisation to acquire more debt for buying new equipments and machinery, which could support its revenue generation capacity. However, during a recession a negative impact occurs on the overall expected profits, which could be attained by the company. This increment in expected profit of organisation mainly increases the overall corporate bonds, which shifts its supply curve (Kang, Ratti and Yoon 2014).

Decrease in business taxes:

 Decline in overall business taxes mainly helps the company in attaining more profits, which in turn motivates business to invest more by using bonds. In addition, the decline in government taxes mainly helps companies to improve their retained profits. This increment in the retained profits mainly helps the company in issuing more bonds, whose capital could be used in its expansion process (Greenwood, Hanson and Vayanos 2015).

Rise in expected inflation:

The overall increment in inflation rate mainly decreases the overall return, which could be provided from investing in bonds. This decline in overall return from investment in bond mainly initiates high selling, which increases the overall supply of bond. Consequently, the increment in inflation rate main instigates high borrowings by issuing bonds, which are conducted by both corporate and government. This high issue of new bond mainly increases the overall supply in the market, which in turn shifts the supply curve of the bond (Becker and Ivashina 2014).

Rise in government borrowings:

Government mainly issue bonds if expenses exceed the overall amount collected from tax. In addition, government mainly use bonds for supporting the overall expenses conducted on public development, which help in improving infrastructure and increase development. The government mainly acquire debt by issuing bond, which could support the required expenditure on public developments. Furthermore, the rise in overall deficit of the government is mainly supported by increasing supply of bond. This increment in the bond supply mainly shifts the supply curve (Wang, Weiz and Zhong 2015).

 

References:

Ballotta, L. and Kyriakou, I., 2015. Convertible bond valuation in a jump diffusion setting with stochastic interest rates. Quantitative Finance, 15(1), pp.115-129.

Brockington, D., Bond, P., Büscher, B., Igoe, J.J., Sullivan, S. and Bracking, P.W.S., 2014. Initial Research Design:‘Human, non-human and environmental value systems: an impossible frontier?’.

Bielecki, T.R. and Rutkowski, M., 2013. Credit risk: modeling, valuation and hedging. Springer Science & Business Media.

Badertscher, B.A., Givoly, D., Katz, S.P. and Lee, H., 2015. Private ownership and the cost of debt: Evidence from the bond market.

Greenwood, R. and Vayanos, D., 2014. Bond supply and excess bond returns. Review of Financial Studies, 27(3), pp.663-713.

Becker, B. and Ivashina, V., 2014. Cyclicality of credit supply: Firm level evidence. Journal of Monetary Economics, 62, pp.76-93.

Wang, S., Weiz, K.C. and Zhong, N., 2015. The Demand Effect of Yield-Chasing Retail Investors: Evidence from the Corporate Bond Market.

Brissimis, S.N., Garganas, E.N. and Hall, S.G., 2014. Consumer credit in an era of financial liberalization: an overreaction to repressed demand?. Applied Economics, 46(2), pp.139-152.

Mina, A., Lahr, H. and Hughes, A., 2013. The demand and supply of external finance for innovative firms. Industrial and Corporate Change, 22(4), pp.869-901.

Kang, W., Ratti, R.A. and Yoon, K.H., 2014. The impact of oil price shocks on US bond market returns. Energy Economics, 44, pp.248-258.

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.

Di Asih, I.M. and Rosadi, D., 2015, February. One period coupon bond valuation with revised first passage time approach and the application in Indonesian corporate bond. In THE 2ND ISM INTERNATIONAL STATISTICAL CONFERENCE 2014 (ISM-II): Empowering the Applications of Statistical and Mathematical Sciences (Vol. 1643, No. 1, pp. 391-401). AIP Publishing.

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