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MGT411 - Money & Banking - Lecture Handout 15

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SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK

  • Shifts in Equilibrium in bond market
  • Bond and Risk
  • Default Risk
  • Inflation Risk
  • Interest Rate Risk

Shifts in Equilibrium

An increase in expected inflation:

  • An increase in expected inflation shifts bond supply to the right and bond demand to the left.
  • The two effects reinforce each other, resulting in a lower bond price and a higher interest rate

Effect of an increase in expected inflation

A business-cycle downturn:

  • A business-cycle downturn shifts the bond supply to the left and the bond demand to the left.
  • In this case the bond price can rise or fall, depending on which shift is greater.
  • But interest rates tend to fall in recessions, so bond prices are likely to increase

Effect of a business cycle down turn

Bonds and Risk

Sources of Bond Risk

  • Default Risk
  • Inflation Risk
  • Interest-Rate Risk

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