CP1 Notes - Ch11 - Page16

[Darragh Kelly]

Hi,

Just finding it difficult to follow the solution to the question on pg 16 of chapter 11. Below is my interpretation:

Demand Side:
If yields are rising then bond prices will be falling. If prices are falling then demand for bond prices will be lower and hence for all investments in the economy? So the yield curve is not just applicable to bonds but general investments in the economy as a whole? Why are index-linked stocks and general investments seperated?

Supply Side:
So with increased supply of investments, then price has to fall. And we know price is falling if yield curce is upward sloping? Again the yield curve is applicable to all investments not just bonds?

Thanks,

Darraagh

 

[James Nunn]

Hi Darragh

A real-yield curve (showing future investment return expectations net of inflationary expectations by term of investment) will be based on real (ie index linked) risk-free bonds. Government bonds in developed countries are generally considered to be risk free as they have a negligible probability of default.

This is why there is a particular focus on index-linked bonds and government ones in particular in the solution - this yield curve will be directly impacted by things impacting these bonds given it's based on them (not other investments).

However, as the solution covers, many things that impact these bonds index-linked bonds, and hence the real-yield curve, will impact on other investments.

Also, changes in other investments can impact on index-linked bonds and hence the real-yield curve. For example, equities may be seen as a 'real' asset like index-linked government bonds. Therefore, all else being equal, if equities get cheaper, investors may be more attracted to them, decreasing demand for the bonds and so bringing their price down and increasing (real) yields.

Hopefully this helps.

 

[Darragh Kelly]

Thanks James that's very clear explaination.

Cheers,

Darragh