Fundamentals of Bonds Markets

Government securities could allow for a better allocation of financial resources and strengthen the government capacity to support the development process, while providing an investment opportunity to savers. In addition, government securities creates reference prices for the development of the private sector domestic debt market.

The following presentation, that is based on Frederic Mishkin and Stanley Eakins “Financial Markets and Institutions”, provides the fundamentals of bonds markets. It introduces the present value concept and presents four applications: a simple loan, a fixed-payment loan, a coupon bond, and a discount bond. It explains that the theoretical fair price of a bond is determined by the present discounted value of its expected cash flows. It defines the yield to maturity as the interest rate that equates today’s value with the present value of all future payments. It shows that prices and yields are inversely related. It talks about the distinction between interest rates and returns. It explains that reinvestment risk occurs, given the uncertainty of the evolution of interest rates, when holding a series of short bonds over long holding period. 

In addition, the presentation introduces the bond market and its equivalence with the loanable funds market. It discusses the determinants of demand and supply and the market equilibrium. It presents comparative statics in response to a change in expected inflation and in response to a business cycle expansion. It shows the potential distortion of introducing a minimum price (maximum yield) above (below) the market equilibrium. Finally, it uses this understanding to discuss the factors affecting the risk structure of interest rates.

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