CA1 Paper 1 April 2015 Qsn 5 (ii)

[nyaman]

From the solution in ASET under the heading "supply and demand", it is indicated that the yield of bonds will be affected by supply and demand. For example, if the government issues a significant volume of bonds to fund a deficit then yields will reduce.
I was of the opinion that an increase in the supply of bonds with no changes in demand will cause a decrease in the price of bonds which will lead to an increase in the bond yields. I am not quite getting why the yields, in this case, will reduce with an increase in the supply of bonds.

 

[Lindsay Smitherman]

Hi - yes you are correct but it sounds like you are using an old version of the ASET product? This is a typo that was corrected when we spotted it in 2019 (as listed in our 'Corrections to 2019 materials' document, which is still available on the website).

The point reads:
The yields on bonds will be affected by supply and demand. For example, if the government issues a significant volume of bonds to fund a deficit then yields will increase.

 

[nyaman]

Hi - yes you are correct but it sounds like you are using an old version of the ASET product? This is a typo that was corrected when we spotted it in 2019 (as listed in our 'Corrections to 2019 materials' document, which is still available on the website).

The point reads:
The yields on bonds will be affected by supply and demand. For example, if the government issues a significant volume of bonds to fund a deficit then yields will increase.

Thanks for the clarification Lindsay. Indeed I am using an old version of ASET. I will look up the corrections document you mentioned.

 

[AKS01]

Hi,

On the same question, the examiners report states:
"Even where these option are significantly out of the money, or currently unlikely to be exercised they have a potential value and hence lead to a higher yield."
I would have thought that the yield on the bonds would reduce if there is an option as it is a risk for the issuer rather than the holder of the bond?

 

[James Nunn]

Hi AKS01

It's actually the issuers (the borrowers) rather than the holders of bonds (the lenders) with redemption date options (callable bonds in the real world) that usually chose the date of redemption. The holders of these bonds will therefore be faced with more uncertainty - ie risk - as to when they will receive the redemption amount. They will therefore need more reward to compensate for this additional risk, so the redemption yield offered will need to increase to entice them to buy these bonds (ie lend money to the issuer/borrower). Or, looking at it in a different way, the prospective holder of these bonds will only be prepared to pay a lower price for the bond as a result of the uncertainty in the timing of the redemption payment, and a lower price means a higher gross redemption yield.

I hope that helps.