CH4

1. Wealth

2. Expected Return 3. Risk 4. Liquidity Asset a piece of property that is a store of value

Pearson Prentice Hall Financial Markets and Institutions 4 - 1

Determinants of Asset Demand

1. Wealth - total resources owned, including all assets 2. Expected Return - return expected over the next

period) on one asset relative to alternative assets

3. Risk - degree of uncertainty associated with the return 4. Liquidity - the ease & speed with which an asset can be

turned into cash



Ceteris paribus -

1. Wealth - an increase in wealth raises the quantity demanded of an asset

2. Expected Return - weighted average of all possible returns, where the weights are the probabilities of occurrence of that return: Re = p1R1 + p2R2 +. . . + pnRn *an increase in an assets expected return relative to that of an alternative asset, raises the quantity demanded of the asset



Ceteris paribus

3. Risk - the degree of uncertainty associated with the return; a measure of risk called the standard deviation (). The standard deviation of returns on an asset is calculated as:

* Square root of the weighted squared deviations from the expected return (Re)

= p1(R1 - Re)2 + p2(R2 - Re)2 +. . . +pn(Rn - Re)2 * if an assets risk RISES relative to that of alternative assets, its quantity demanded will FALL



Ceteris paribus

4. Liquidity - the ease and speed with which an asset can be turned into cash An asset is liquid if the market in which it is traded has depth and breadth, i.e., if the market has many buyers and sellers Treasury bill - a highly liquid asset; well-organized market * The more liquid an asset is relative to alternative assets, the more desirable it is, and the greater will be the quantity demanded



Summary response: Change in Change in Variable Quantity Demanded

1. Wealth h h 2. Expected Return h h 3. Risk h i 4. Liquidity h h



Example: 1-yr Discount Bond, Face vale, $1000 Holding Pd: 1 yr Re = i = F P P


Demand & Supply Curves

Equilibrium Pt

Demand Curve Bd : downward slope, indicating that at LOWER prices of the bond, ceteris paribus, the quantity demanded is HIGHER

Supply Curve Bs : upward slope, indicating that as the price

increases, ceteris paribus, the quantity supplied is INCREASES Market Equilibrium : Quantity Demanded = Quantity Supplied or Market-Clearing Price Bd = Bs



Market Implications

vWhen the PRICE of bonds is set too HIGH: Bs > Bd : Excess Bs people want to SELL more bonds than others want to buy,

the price of the bonds will FALL;

as long as price is above equilibrium, it will continue to fall vWhen the PRICE of bonds is set too LOW: Bs < Bd : Excess Bd

people want to BUY more bonds than others want to sell, the price of the bonds will BE DRIVEN UP;

as long as price is below equilibrium, it will continue to rise



Movements along the Curve vs Shifts in the Curve

v ALONG the Curve: rQty due to rPRICE or rInterest Rate (i)

v SHIFT in the Curve: r Qty at each given PRICE or Interest Rate - in response to r in some factors beside PRICE or i


Changes in Equilibrium Interest Rates

Shifts in the Demand for Bonds

1. Wealth 2. Expected returns on bonds relative to alternative

assets 3. Risk of bonds relative to alternative assets 4. Liquidity of bonds relative to alternative assets



If h, h Economy is growing rapidly, expans ion & wea l th i s increasing, the demand curve shifts to the RIGHT;

Recession: income & wealth are falling, the demand for bonds falls, and the demand curve shifts to the LEFT.


Changes in Equilibrium Interest Rates Shifts in the Demand for Bonds: WEALTH

If h, i Higher expected interest rates in the future i the expected return for LT bonds, ithe Bd, and shift the curve to the LEFT;

Lower expected interest rates: RIGHT.


Changes in Equilibrium Interest Rates Shifts in the Demand for Bonds: EXPECTED RETURNS

If h, i Higher expected ination rates in the future i the expected return for LT bonds, ithe Bd, and shift the curve to the LEFT;

Lower expected ination rates: RIGHT.


Changes in Equilibrium Interest Rates Shifts in the Demand for Bonds: EXPECTED INFLATION

If h, i

Increase in riskiness i the bonds become less attractive, ithe Bd, and shift the curve to the LEFT;


Changes in Equilibrium Interest Rates Shifts in the Demand for Bonds: RISK

If h, h More people started trading in the bond market, and as a result it became easier to sell bonds quickly; hliquidity of bonds results in an hBd, the demand curve shifts to the RIGHT;

h l iquidity of ALTERNATIVE ASSETS iBd, shifts the demand curve to the LEFT.


Changes in Equilibrium Interest Rates Shifts in the Demand for Bonds: LIQUIDITY

Shifts in the Supply for Bonds

1. Expected protability of investment opportunities 2. Expected ination 3. Government budget



If h, h Economy is growing rapidly, business cycle expansion, Bs is increasing, the supply curve shifts to the RIGHT;

Recession: fewer expected protable investment opportunities, and the supply curve shifts to the LEFT.


Changes in Equilibrium Interest Rates Shifts in the Supply for Bonds: PROFITABILITY

If h, h Real cost of borrowing i, business cycle expansion, Bs is increasing, the supply curve shifts to the RIGHT

FISHER EFFECT: When expected ination rises, interest rates will rise


Changes in Equilibrium Interest Rates Shifts in the Supply for Bonds: EXPECTED INFLATION

If h, h Decit: Government borrows by issuing Treasury Bonds, Bs is increasing, the supply curve shifts to the RIGHT;

Surplus: supply curve shifts to the LEFT.


Changes in Equilibrium Interest Rates Shifts in the Supply for Bonds: GOVERNMENT BUDGET

Analysis assumptions:

1. Examine the eect of a variable change, remember that we are assuming that all other variables are unchanged; that is, we are making use of the ceteris paribus assumption

2. INTEREST RATE is negatively related to the BOND PRICE, so when the equilibrium bond price rises, the equilibrium interest rate falls. Conversely, if the equilibrium bond price moves downward, the equilibrium interest rate rises.



CH4

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