BOND PRICE

MOVEMENTS
RUIZ, BEA FRITZ D.
BOND PRICE MOVEMENTS
• The
  price of the bond should reflect the present value of future cash flows, based
on a required rate of return. Therefore, the higher the rate of return, the lower the
bond price is, and vice versa.

– Where:
• - price of a bond
• K – required rate of return per period used to discount a bond
GENERAL PRICE MOVEMENTS
•  general price movements of the bonds can be modeled as:

– Where:
• - risk-free rate
• Rp – credit risk premium
FACTORS THAT AFFECT RISK-FREE RATE
•  

• INF – Impact of Inflationary expectations

• ECON – Economic Growth
• MS – Money Supply Growth
• DEF – Budget Deficit
IMPACT OF INFLATIONARY EXEPCTATIONS
• If the level of inflation is expected to increase, there will be upward pressure on
the interest rates and hence on the required rate of return on bonds. And vice
versa
• Inflation decreases the purchasing power of a bond's future cash flows
• Partly dependent on oil prices, which affect the cost of energy and transportation
IMPACT OF ECONOMIC GROWTH
• Stronger economic growth tends to generate upward pressure on interest rates,
while weak economic conditions put downward pressure on rates.
• Bond participants closely monitor economic indicators that may signal future
changes in the strength of the economy, which signal changes in the risk-free
interest rate and in the required return from investing in bonds.
• Indicators of economic growth includes employment, gross domestic product,
retail sales, industrial production and consumer confidence
IMPACT OF MONEY SUPPLY GROWTH
• More money flowing through the economy corresponds with lower interest rates,
while less money available generates higher rates.
• The money supply is influenced by supply and demand, and the actions of the
BSP and commercial banks.
IMPACT OF BUDGET DEFICIT

• As the annual budget deficit changes, so does the government’s demand

for loanable funds. An increase in the annual budget deficit over the
previous year results in a higher level of borrowing by the federal
government, which can place upward pressure on the risk-free interest
rate
FACTORS THAT AFFECT THE CREDIT RISK
PREMIUM
•  

– ECON - Change in Economic Growth

• Strong Economic Growth tends to improve a firm’s cash flows and reduce the probability
that the firm will default on its debt payments

• Conversely, weak economic conditions tend to reduce a firm’s cash flows and increase the
probability that it will default on its bonds
IMPACT OF ISSUER-SPECIFIC
CHARACTERISTICS ON CREDIT RISK
• A bond’s price can also be affected by the factors specific to the issuer of the
bond, such as change in its capital structure.
• If a firm subsequently obtains additional loans, it may be less capable of making
its coupon payments and so its credit risk increases.
IMPLICATIONS FOR FINANCIAL INSTITUTIONS

• If they anticipate that the risk premiums of risky bonds will increase, they shift
toward relatively safe bonds that exhibit less credit risk.
• When they expect interest rates to rise, they sell bonds and use the proceeds to
purchase short-term securities that are less sensitive to interest rate movements.
SYSTEMIC RISK
• The potential collapse of the entire market of financial system.
• Some financial institutions use their investments in debt as collateral when
borrowing funds, but this collateral may no longer be acceptable during a credit
crisis
• Although theses securities could protect some participants during a credit crisis,
they can result in major losses for the counterparties
• Financial reform act of 2010