Question

This part of the assignment is purely conceptual with no computations required. Explain the following with references to the required readings:

What is likely to happen to interest rates if the rate of inflation suddenly increases?

Suppose there are two bonds each with coupon payments of $50. The first bond pays $1,000 in five years, and the other one pays $1,000 in ten years. If interest rates increased, would the value of the bonds increase or decrease? Which of the two bonds would have their value change more after the increase in interest rates? Explain your reasoning.

Answer 1

What is likely to happen to interest rates if the rate of inflation suddenly increases?

When there is a sudden spurt in inflation, Interest rates are likely to increase.

But why....... ? ( Reasoning)

A raise in interest rates will motivate savings, insteaded of expenditure ( whether revenue or capital ) .. thus policy makers achive decrease in consumption and as a result, Inflation starts decreasing.

If interest rates increased, would the value of the bonds increase or decrease?

If Interest rates increased, bonds value will decrease. Because current interest rates becomes attractive for investments, compared to those already made at lower rates in past.

Which of the two bonds would have their value change more after the increase in interest rates?

A bond with more maturity ( all else is constant) is likely to have more interest rate risk. Hence, Bond - 2 with 10 years is likely have its value change more after the increase in interest rates.

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