Question

1. Explain how factors affecting bond market is able to explain the movement of interest rates?( 15 marks)

2. Why in the long run, the profits of holding a domestic financial assets is equivalent to the profits of holding a foreign assets? ( 20 marks)

Answer 1

1. Factors affecting bond market is able to explain the movement of interest rate because when the interest rates by Federal Reserve is cut or increased, it will have direct impact on the prices of the bond because interest rates and bond prices are inversely related.

It will mean that when the interest rates are going to go up, the bond prices are going to go down, and when the interest rate is going to fall, the bond prices are going to go up.

It can also be said that the interest rates are directly reflected into the bond prices through the bond yields as bond yields are tradable in nature and they are also inversely related to the bond prices, and interest rates are always seen as a a opportunity cost for bond yields because a subsequent change in the bond yield will mean that the bond prices will also change and that will affect the coupon rate of the bondas they will be compared with the interest rates and they can be seen as less attractive or more attractive.

so there is a chain of interrelation between movement of interest rates and bond markets

2. Profits of a domestic financial asset is equivalent to the profits of holding an asset because of purchasing power parity as there are various factors like interest rates and inflation, which are are making the currency rates of two different countries equivalent to each other and when they are acting with one another there will be a equivalent in the prices of both the currency as interest rates and inflation are the factors deciding upon the prices of financial assets.

it advocates that the price of financial assets will be same in two different countries because of difference in exchange rate and difference in inflation rates.