Albay, Jeremy James G.

BSA-3A
Assignment 3: Debt security markets – bond valuation and risk and mortgage markets

1. Explain the impact of a decline in interest rates on:

a. An investor’s required rate of return
b. The present value of existing bonds
c. The prices of existing bonds

If there is a decline in interest rates on bonds, it affects differently each element of a

bond. For example, a decline in interest rate would decrease the investor’s required rate of return
as they have direct relationship to each other. One of the main factors affecting the required rate
of return is interest rate and risk premium therefore if the interest rate alone is declining, it will
be the same for the required rate of return. On the other hand, PV or present value of the bond
will increase as interest rate decrease. It has inverse relationship to each other. Same relationship
could be said when it comes to its price.
To demonstrate this, let’s say a bond with an interest rate of 10% would have a present
value of P10,000. If the prevailing interest rate moved and decreases to 5%, then suddenly the
10% bond would be of course more attractive than the 5% and with that, to match the yields of
newly released bonds with 5% rates, the existing bonds with 10% rate should increase in value
(more than P10,000). Therefore, both present value and price of bonds move inversely to interest
rates (in this case, declining interest rates = increased PV and price).

2. What is the general relationship between mortgage rates and long-term government
security rates?

Mortgages are long-term debts and lasts typically for 15-30 yrs. With that, mortgage rates
are generally moving in tandem (direct relationship) with long-term government security rates
because of their similarity in nature, both long-term debts. The only difference with the two is
that, government-issued debts are risk-free because government doesn’t possess credit risk
meanwhile mortgages do. Those who borrows money through mortgages are subjected to criteria
checking their ability to repay their loans. Thus, mortgage rates carry risk premiums to
compensate the risk making the rates higher compared to long-term government security rates.
Still, if long-term government security rates increase, mortgage rates also increase, generally.
However, some types of mortgages are not affected by interest rates in the market, which is
called the fixed-rate mortgages.