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Chapter 5: Q.4 (page 164)

Explain why you would be more or less willing to buy long-term Delta Air Lines bonds under the following circumstances:

a. The company just released its financial statements, indicating that income decreased and liabilities increased.

b. You expect a bull market in stocks (stock prices are expected to increase).

c. You have analyzed your country鈥檚 monetary policy and expect interest rates to decrease.

d. Brokerage commissions on bonds fall.

e. Your income and wealth increased over the last two years.

Short Answer

Expert verified

Part (a) If bond trading increases, people will be more inclined to acquire long-term corporate bonds.

Part (b) If an investor anticipates a bear stock market, he or she will be more willing to purchase corporate long-term bonds.

Part (c) Long-term corporate bonds would be less appealing.

Part (d) If interest rates are predicted to rise, people will be less likely to buy the bond.

Part (e) Long-term corporate bonds would be less appealing.

Step by step solution

01

Introduction

The amount demanded of an asset is directly related to wealth, expected return on asset, and liquidity of the asset, and negatively proportional to expected return on alternative asset, liquidity of the alternate asset, according to the theory of portfolio choice.

02

Explanation to part (a)

If bond trading increases, people will be more inclined to buy long-term corporate bonds since more trading means greater liquidity. Because of the increased liquidity, the investor will be able to convert his bond into cash at any time.

As a result, if bond trading increases, people will be more inclined to acquire long-term corporate bonds.

03

Explanation to part (b)

If an investor expects a bear stock market, he or she will be more ready to buy corporate long-term bonds because the relative return on bonds will be higher. This means that bonds offer a higher rate of return than equities.

As a result, if an investor anticipates a bear stock market, he or she will be more willing to purchase corporate long-term bonds.

04

Explanation to part (c)

If the stock brokerage commission reduces, the return on the stock will rise, and people will be less likely to buy long-term corporate bonds because they can now earn more money by buying stock.

As a result, long-term corporate bonds would be less appealing.

05

Explanation (d)

If a person believes that the interest rate will climb, he will be less willing to purchase the bond. The price of the bond lowers as the interest rate rises, making it a less desirable investment.

As a result, if interest rates are predicted to rise, people will be less likely to buy the bond.

06

Explanation to part (e)

If the brokerage commission on bonds decreases, the return on the bonds will increase, and as a result, people will be more eager to acquire long-term corporate bonds because they can now earn more money by buying today and selling later.

As a result, long-term corporate bonds would be less appealing.

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Most popular questions from this chapter

Suppose that people in France decide to permanently increase their savings rate. Predict what will happen to the French bond market in the future. Can France expect higher or lower domestic interest rates?

Go to the St. Louis Federal Reserve FRED database, and find data on the M1money supply (M1SL) and the 10-year U.S. Treasury bond rate (GS10). For the M1money supply indicator, adjust the units setting to 鈥淧ercent Change from Year Ago,鈥� and for both variables, adjust the frequency setting to 鈥淨uarterly.鈥� Download the data into a spreadsheet.

a. Create a scatter plot, with money growth on the horizontal axis and the 10-year Treasury rate on the vertical axis, from 2000:Q1to the most recent quarter of data available. On the scatter plot, graph a fitted (regression) line of the data (there are several ways to do this; however, one particular chart layout has this option built in). Based on the fitted line, are the data consistent with the liquidity effect? Briefly explain.

b. Repeat part (a), but this time compare the contemporaneous money growth rate with the interest rate four quarters later. For example, create a scatter plot comparing money growth from 2000:Q1with the interest rate from 2000:Q1, and so on, up to the most recent pairwise data available. Compare your results to those obtained in part (a), and interpret the liquidity effect as it relates to the income, price-level, and expected-inflation effects.

c. Repeat part (a) again, except this time compare the contemporaneous money growth rate with the interest rate eight quarters later. For example, create a scatter plot comparing money growth from 2000:Q1with the interest rate from 2002:Q1, and so on, up to the most recent pairwise data available. Assuming the liquidity and other effects are fully incorporated into the bond market after two years, what do your results imply about the overall effect of money growth on interest rates?

d. Based on your answers to parts (a) through (c), how do the actual data on money growth and interest rates compare to the three scenarios presented in Figure 11of this chapter?

Would fiscal policymakers ever have reason to worry about potentially inflationary conditions? Why or why not?

The president of the United States announces in a press conference that he will fight the higher inflation rate with a new anti-inflation program. Predict what will happen to interest rates if the public believes him.

1. Explain why you would be more or less willing to buy a share of Microsoft stock in the following situations:

a. Your wealth falls.

b. You expect the stock to appreciate in value.

c. The bond market becomes more liquid.

d. You expect gold to appreciate in value.

e. Prices in the bond market become more volatile.
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