DISCUSSION ASSIGNMENT: It is important to estimate risk and return for both individual assets and portfolios. Discussing the relationships between these will provide a better understanding of how greater the probability is of actual returns.
Discussion Topic: Bond Prices and Interest Rates
Discuss the relationship between the price of a bond and interest rates. Why does the price of a bond change over its lifetime? Please offer a quantitative example to demonstrate this relationship.
In the real world, is it possible to construct a portfolio of stocks that has an expected return equal to the risk-free rate? Provide examples.
PLEASE WRITE A REPLY TO THESE PEOPLE BELOW: A SOLID 2 PARAGRAPH WILL DO WITH A REFERENCE: DISCUSSION RESPONSES:
((Taylor Barnick))
There is an inverse relationship between bond prices and interest rates. That means that when one moves in a certain direction, the other moves in the opposite direction. This is because individuals purchase bonds at a higher rate when interest rates fall because their payouts are more attractive. Demand and price typically follow the same trajectory. If demand for a bond is high, the price rises as people bid up the price. If demand for a bond is low, the price of the bond sinks along with it. (Brigham & Ehrhardt)
An example of this converse relationship would be that if there was a company selling a bond that had a market interest rate of 15% (up recently by 10%), the price of the bond would fall. The bond would now sell for lower than the previous value, due also to demand dropping. If the market interest rates decreased to 5% (from 15%), the price of the bond would rise along with demand for that bond. (Brigham & Ehrhardt)
It is possible to construct a portfolio of stocks that has an expected return equal to the risk-free rate. This is done by having a diversified portfolio where stocks that are included have a wide range of correlation coefficients ranging from -1 to +1, so that in the end they cancel each other out. Brigham & Ehrhardt (2020) state that this is done by choosing stock options that “completely cancel out the other stock’s deviations from its mean return.” This can be done by using the Capital Asset Pricing Model (CAPM) which allows you to measure the relevant risk a stock would have on a well-diversified portfolio. (Brigham & Ehrhardt)
References
Brigham, E. & Ehrhardt, M. (2020). Financial Management: Theory & Practice. Cengage Learning.
((David Hayashi))
The price of a bond and market interest rates have an inverse relationship. As the market interest rates decrease, the price of outstanding bonds rises. On the contrary, as the market interest rates increase, the price of outstanding bonds decreases. Additionally, demand moves in the same direction as price.
When there is more demand for bonds the bond prices increase and when there is less demand for bonds the bond prices decrease. The price of a bond changes over its lifetime due to several factors. Although the coupon rate of a bond remains fixed after issuance, the interest rates and inflation rates change with the market. When the interest rate is above the coupon rate the bond’s price falls below its par value and is called a discount bond. When the interest rate is below the coupon rate the bond’s price rises above its par value and is called a premium bond.
An example of the inverse relationship between the price of a bond and interest rates is if a bond has a yield of 5%. If the market rate during the period increased to 10% then more people would invest in the market than in bonds to benefit from the extra 5% yield. This causes the demand for bonds to decrease and likewise the price of bonds to decrease. The bond prices will decrease to the point where the yield matches the 10% market rate.
In the real world, it is possible to construct a portfolio of stocks that has an expected return equal to the risk-free rate. The textbook gives the formula of Required return on stock A= risk-free rate + (beta of stock A) *(market risk premium) (Brigham & Ehrhardt, 2020, p. 266). We can rearrange the formula to read Risk-free rate= Required return on stock A – (beta of stock A) *(market risk premium). In this example if we assume the risk-free rate is 7%, the required return on stock A is 7%, the beta of stock A is 0, and the market risk premium is 4% then both sides of the equation would be equal. Therefore, in this example, the stock has an expected return equal to the risk-free rate because the beta was 0 causing the required return on stock A to equal the risk-free rate.
References
Brigham, E. & Ehrhardt, M. (2020). Financial Management: Theory & Practice. Cengage Learning.
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