Re: For our bond experts: Would it be correct to say....?
From: Bill (xxx_at_yy.zz)
Date: 01/02/05
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Date: Sun, 02 Jan 2005 23:29:42 GMT
"Edward" <sorry@nospam.com> wrote in message news:cr9t6r$t1s$1@gist.usc.edu...
> I'll assume that for short-term bonds/bills broker-dealers buy them at a
> discount and limit this conversation to only 5 year + instruments.
>
> I'm assuming that the usual situation is one in which a bond, at issue, has
> both an interest rate and a face value imprinted on it. These bonds I'm
> assuming are auctioned off and purchased by the broker-dealers who bid the
> highest for the bond.
>
> Using the definition that the nominal rate of interest i = r + pi, where r
> is the real rate of interest and pi is the premium for inflation required by
> investors:
>
> The usual situation I am assuming to be the following: Assume there is a
> rapid increase in GDP. Then investors get worried about inflation and
> require a higher pi (for a fixed r), thus i increases. Therefore, the price
> of that bond in the market decreases because if you think of the price of a
> bond as equaling its Present Value of future cash flows, then that present
> value would now be lower since we are discounting each future payment using
> the higher i.
>
> A converse agrument for expectations of decreasing inflation could similarly
> be made.
>
> Is this more or less correct?
>
> As second question, if the above process is moreless correct, then it is the
> subsequent price of bonds which fluctuate in the market. How then are the
> rates of mortgages determined off of this process?
>
> Edward
>
>
I'm not a bond expert, but other things enter into it - most prominently the
likelihood of the bond paying off, or perhaps you have included that in your
"r". Other things like the balance of trade enter in - if China has more US
dollars is buys more treasuries and also US mortgages, which it has been doing
recently.
In the end the whole thing is supply and demand. If the US should suddenly cut
the supply of new US treasury bonds (not too likely) and that looked like it
would continue, bonds would be more valuable, prices would rise and interest
rates would fall. This would apply more to the long term than short term -
holding a scare thing is better for 5 years than 6 months. And it would be
limited by other markets which compete with the US Treasury market.
Bill
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