Research Proposal on "Bond Pricing and Inflation Rates"

Research Proposal 6 pages (1833 words) Sources: 3 Style: APA

[EXCERPT] . . . .

Bond Pricing

The most fundamental principle with respect to pricing any investment is that today's price will be equal to the net present value of the expected future cash flows. If this were not the case, there would be an arbitrage situation and the subsequent market activity would bring the price back into equilibrium. This efficient market theory, however, requires several assumptions to work. The first is that investors behave rationally. It is widely accepted that this is not the case (The Economist, 2009). This may have, at one point in time, been the case, but we have seen substantial bubbles of late. Investors are prone to emotion -- they panic, they fear and they get overexcited.

The second major assumption in efficient market theory is that investors have perfect information. This again has been shown to be unlikely. Even if we took information availability to be perfect, the complexity levels are high, making it difficult for all investors to understand. With easy market access, however, they are able to act even if they do not have perfect information. Combined with fits of irrationality, we get significant market distortion. The assumptions are more bluntly applied to the stock market, which seems to attract the bulk of uninformed, irrational participants, but the bond market is also subject to these forces as well.

In theory, bond pricing works within the confines of efficient market theory. Yet there remains a range of assumptions that must be made. Why are investors irrational? Why do they work with imperfect information? In part, they do so because they know these two assumptions are not strictly correct. This means that in any market, for any given security, there is opportunity for arbitrage. Indeed, the constant fluctuations in stock and bond prices represent individual attempts at gaining some arbitrage, taking advantage of a security that is deemed to be temporarily over- or under-priced. The reason investors feel that this opportunities exist is in part because the nature of future cash flows is unknown. Investors estimate the value of those cash flows based on sets of assumptions.

In bond pricing, the future cash flows are known. The amount and dates of interest and principle payments are known. The variable that remains unknown is the value of those flows. That can be determined through a number of different means, using a number of different assumptions.

The simplest way to understand present value as applied to bond pricing is that the discount rate used to value the future cash flows is the rate at which we assume that each flow can be reinvested. This rate is not only going to be applied at some point in the future, but it will fluctuate for each flow. Those fluctuations occur as a result of changes in the prevailing interest rates. So what affects the prevailing interest rates? A number of factors do, but the government is a major influencer.

At their base, interest rates reflect the risk of lending money (Heakal, 2009). Different risk levels are assigned different rates -- more risk equates to a higher rate. In bond pricing, the firm-specific risk is assigned a particular value, and this is reflected in the price of the bond relative to par. The other risk, which is reflected in the discount rate, is the risk associated with the economy.

The reason this risk is considered to be broad economic risk is that it reflects the rate at which the cash flows can be reinvested. This is taken to be a basic government rate. The reason is because government securities are considered to be risk free. If a risk-bearing security was assumed to be the source of the reinvestment rate, then we would be unable to derive a fair value for the bond. Each investor would have a different rate that is used, and the result would be a scenario where any given bond could have a price that fluctuates wildly. Using a risk-free rate creates a level playing field whereby the true value of those cash flows can be established, allowing for the establishment of a fair price for the bond.

Another reason that investors pay attention to the prevailing rates on government securities is in order to establish a level for the firm-specific risk. Treasury bonds are viewed as having no risk, because the government can print money in order to make payments. If the government is essentially bankrupt, inflation could devalue those flows to the point where they are worthless, but you will always receive those flows.

There are other considerations as well in bond pricing. Each bond represents a different basket of underlying assets, thus each bond behaves differently. The yield responds to changes in interest rates, but the price does not respond to such changes in a uniform matter. This is known as convexity, the degree to which a bond price changes when interest rates change. The greater a bond's convexity, the higher its price will be, reflecting the higher level of volatility. While convexity is taken into account with respect to individual bonds, it merely reflects a relationship between interest rates and prices, and is not a force that impacts either. Interest and inflation rates are the forces that impact prices, and are therefore the most important variables in bond pricing.

The Capital Asset Pricing Model (CAPM) tells us that risk-bearing securities are priced in accordance with a risk premium. This means that the prevailing interest rates are also a guideline for the systemic risk. Each bond is then priced in accordance with the risk level of its underlying assets based on that systemic risk. Underlying firms and governments are assigned bond ratings, which are intended to reflect the value and safety of the underlying assets. Bond prices, then, reflect this relative degree of risk. Bond ratings, however, are just a form of information in the marketplace. They do not hold any specific value beyond the information they convey.

So we can see that, within the framework of CAPM and discount rates, bond prices are heavily influenced by the interest rates that government sets. The yield curve on Treasury bonds is typically incorporated into bond prices as a result. So how is the yield curve on Treasury bonds derived?

Interest rates are set by the Federal Reserve in order to control the money supply. The basic rule of thumb is that low rates increase the money supply and high rates contract the money supply. In doing this, the Federal Reserve is attempting to set the tone for the future direction of the economy. All things being equal, the Federal Reserve prefers to keep interest rates relatively low. This facilitates economic expansion and is generally desirable.

Economic expansion, however, must be within the constraints of capacity. When the economy pushes up against capacity, the result is inflation. Inflation devalues money. The higher the rate of inflation, the less future cash flows are worth. This has a strong impact on bond pricing, because the amount and timing of those cash flows is a constant. The only thing that fluctuates is the value of those flows.

The government cannot set the rate of inflation. It can merely exert influence on it. The body in charge of such activity is the Federal Reserve, which operates independent of the White House to control the money supply. The Federal Reserve will typically exert influence on inflation by contracting the money supply, with the intent of slowing down economic expansion and thereby curtailing inflation. Thus, inflation is a potential driver of bond prices. The Fed's reaction to inflation, however, is never certain. While Federal Reserve policy is typically to keep inflation in check, this is not always going to be the case. The Fed always adopts a specific policy with respect to inflation and interest rates at each meeting, based on the unique circumstances that it faces at the time.

Thus, the impact that inflation has on bond prices is dependent on the government's reaction. However, since Fed interest rate policy generally aims to strike a balance between inflation and economic expansion, we can derive some generalities with respect to the impact of inflation on bond prices. Inflation drives down the value of future cash flows. Thus, inflation drives down bond prices and drives up bond yields. The Fed's usual response to inflation is to increase rates, which further drives down prices and drives up yields. From a CAPM perspective, the risk free rate increases and from a discount rate perspective the value of the future flows decreases.

It is important to remember, however, that the Federal Reserve not only sets rates but the statements that it issues set the expectation for future policy. The carefully-worded statements are used in bond markets to attempt to understand future interest rate movements. There have been many instances where, in advance of the Fed's rate announcement, the bond market has already priced in the rate change and only reacts to the expected future direction of rates as derived through… READ MORE

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