On the other hand, lower prices mean higher costs to borrowers-suppliers of bonds-and should reduce the quantity supplied. That makes them more attractive to buyers of bonds and thus increases the quantity demanded. At lower prices, bonds pay higher interest. Can we expect bonds to have the same kind of downward-sloping demand curves and upward-sloping supply curves we encounter for ordinary goods and services? Yes. The interest rate rises to 11.1%.īonds are not exactly the same sort of product as, say, broccoli or some other good or service. An increase in borrowing, all other things equal, increases the supply of bonds to S 2 and forces the price of bonds down to $900. The initial solution here is a price of $950, implying an interest rate of 5.3%. The equilibrium price for bonds is determined where the demand and supply curves intersect. Once a newly issued bond has been sold, its owner can resell it a bond may change hands several times before it matures. Sellers of newly issued bonds are borrowers-recall that corporations, the federal government, and other institutions sell bonds when they want to borrow money. Buyers of newly issued bonds are, in effect, lenders. Their price is determined by demand and supply. Bonds can be resold at any time, but the price the bond will fetch at the time of resale will vary depending on conditions in the economy and the financial markets.įigure 25.1 “The Bond Market” illustrates the market for bonds. The original buyer need not hold the bond until maturity. The lower the price of the bond relative to its face value, the higher the interest rate.īoth private firms and government entities issue bonds as a way of raising funds. Potential buyers bid for the bonds, which are sold to the highest bidders. Newly issued bonds are generally sold in auctions. Buyers of bonds will seek the lowest prices they can obtain. Whatever the period until it matures, and whatever the face value of the bond may be, its issuer will attempt to sell the bond at the highest possible price. The maturity date might be three months from the date of issue it might be 30 years. They have a face value (usually an amount between $1,000 and $100,000) and a maturity date. The lower the price of a bond relative to its face value, the higher the interest rate.īonds in the real world are more complicated than the piece of paper in our example, but their structure is basically the same. A price of $800 would mean an interest rate of 25% $750 would mean an interest rate of 33.3% a price of $500 translates into an interest rate of 100%. Suppose, for example, that the best price the manager can get for the bonds is $900. As the price falls, the interest rate rises. The interest rate on any bond is determined by its price. Bonds you sold command an interest rate equal to the difference between the face value and the bond price, divided by the bond price, and then multiplied by 100 to form a percentage: The difference between the face value and the price is the amount paid for the use of the money obtained from selling the bond.Īn interest rate is the payment made for the use of money, expressed as a percentage of the amount borrowed. The $950 at which they were sold is their price. The $1,000 printed on each bond is the face value of the bond it is the amount the issuer will have to pay on the maturity date of the bond-the date when the loan matures, or comes due. The buyers of the bonds are being paid $50 for the service of lending $950 for a year. Each bond is, in effect, an obligation to repay buyers $1,000. Suppose the highest price offered is $950, and all the bonds are sold at that price. The manager then offers these bonds for sale, announcing that they will be sold to the buyers who offer the highest prices. These pieces of paper are bonds, and the company, as the issuer, promises to make a single payment. The manager could do so in the following way: he or she prints, say, 500 pieces of paper, each bearing the company’s promise to pay the bearer $1,000 in a year. Suppose the manager of a manufacturing company needs to borrow some money to expand the factory.
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