5 This part of the assignment is purely conceptual with no c

5. This part of the assignment is purely conceptual with no com putations required. Explain the following with referencesto the required readings: a. What islikely to happen to interest rates if the rate of inflation suddenly increases? b. Suppose there aretwo bonds each with coupon payments of $50. The first bond pays $1,000 in five years, and the other one pays $1,000 in ten years. If interest rates increased, would the value of the bonds increase or decrease? Which of the two bonds would have their value change more after the increase in interest rates? Explain your reasoning.

Solution

a) If the rate of inflation goes up suddenly, then the Central Bank is most likely to increase the interest rates in order to curb the inflation. When the interest rates go up, the cost of borrowing goes up which leads to a fall in the investments, wages, consumption and finally the inflation rates.

b) Since the second bond has a longer maturity period, when there is a rise in the interest rates, the price of the second bond will see a greater fall. In general, a rise in the interest rate leads to a fall in the bond price as they have an inverse relationship between them. The bond with a longer maturity period would see a greater fall because since the return on bonds are essentially distant cash flows, a rise in the interest rates leads to the distant cash flows being discounted significantly leading to a sharp fall in the price of the bond.