Question

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1.For the same time-to-maturity, a lower coupon bond has a greater percentage price change than a higher-coupon bond when their market discount rates change by the same amount. Explain with examples

2. When the real interest rate is low,there are greater incentives to borrow and fewer incentives to lend.justify your answer with examples

Answer 1

1. Generally, for two bonds with the same time-to-maturity, a lower coupon bond has a greater percentage price change than a higher-coupon bond when their market discount rates change by the same amount. For example, Bond B & Bond C have the same time to maturity (5 years), however Bond B offers a lower coupon rate. Therefore, Bond B will experience a greater percentage change in price in comparison to Bond C.

2. When the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend. The real interest rate is a better indicator of the incentives to borrow and lend.

Real interest rates show the actual cost of borrowing. Let’s take an example, the nominal interest rate is 5% and inflation is zero. You’re thinking of buying a house. You assume then that the price of the house won’t go up at all, so you have to think if you can really pay 5% a year for your money.

On the other hand, if inflation is 7% a year, you can imagine that the value of the house goes up 7% a year too (maybe). In that case, the value of the house will go up every year by more than the interest that you’re paying. You will be paying off your mortgage with money that’s worth less and less each year.

Now let’s look at it from the lender’s point of view. In this case, why should they lend money to you at 5% when their cost of living will go up by 7% a year. They can make more money by buying stuff and holding onto it, or by buying a house and holding it. So the value of their money will be eroded.

So it can be seen that the nominal rate only makes sense against the background of the inflation rate. That is, it’s the real rate of return that matters.