Examine the effects of a change in interest rates on the price of equity and Government bonds. Briefly explain what other major factors affect the price of equity. 1911 Words

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Governments of countries finance many of their activities - for example public and merit goods provision and/or subsidisation - through borrowing from lenders by issuing bonds. In the UK government bonds are known as gilt edged securities and are referred to as 'gilts.' Responsibility for them is managed by the Debt Management Office (DMO) which is an executive agency of the Treasury.. They advise on debt issues and organize the auctions of gilts on behalf of HM Treasury.

As with all forms of assets gilts pay a annual yield, known as the coupon in the gilt edged market. However the coupon isn't a perfect guide to the interest rate the Government had to pay when they issued the gilt because stocks are sometimes issued at a premium or discount o their par value.

The prices of gilts are determined primarily by interest rates but are also influenced by news and technical influences.

Firstly let us examine the effect of a change in interest rates on the price of gilts. This is best explained by a theoretical case involving 3 different stocks#. Suppose that in 2001 the DMO decided to issue 3 stocks with the following details#:

Price Income Yield Redemption Yield

Short-dated 4.5% 2003 100 4.5% 4.5%

Medium -dated 4.5% 20010 100 4.5% 4.5%

Long -dated 4.5% 2025 100 4.5% 4.5%

Suppose that a year later the UK economy has began to deteriate and that there's evidence of inflation growing, and the US economy, a major importer of our goods, is slumping and investors are demanding higher yields to compensate. If the DMO wanted to issue a new gilt at this point they would have to offer a yield of, for example 6%, to persuade investors to buy. It's clear that investors wouldn't buy the 3 stocks above at a price of 100 and a redemption yield of 4.5%. So what price would the investors buy the old stocks at? The prices would have to fall in the market until they offer a 6% redemption yield which investors now expect. The new yields and prices expected are shown in the table below:

Price Income Yield Redemption Yield

Short-dated 4.5% 2003 97.25 4.63% 6%

Medium -dated 4.5% 20010 89.80 5.01% 6%

Long -dated 4.5% 2025 81.20 5.54% 6%

Hence the relationship between prices and interest rates for gilts is inverse. This is because a gilt pays a fixed amount which when calculated as a percentage of its market price, is the yield, equivalent to the rate of interest. This is because if interest rates rise the attractiveness of a deposit account over a bond increases. The price must adjust to make it a favourable investment comparable to a deposit account. It can also be seen from this example that interest rate changes have the greatest effect on long-dated gilts. This is because the pull to redemption is larger with short-dated than long-dated stocks.

However this fall in the value of gilts when interest rates rise sometimes doesn't occur if investors think the rise is only very temporary or unless prices have already fallen in anticipation.

Interest rate changes also have important implications on the price of equity - "used in the sense of the owners interest in an asset, with the risk and rewards of ownership that go with it. Hence it stands for ordinary shares#." The main factors which affect interest rates is the value of sterling - if sterling is weak the Central bank tends to raise interest rates to defend the pound ,- fears of inflation - Central Bank raises interest rates to encourage saving and discourage spending ,- the state of the economy - higher interest rates in a boom and lower ones in a slump.

So what is the effect of interest rate changes on the price of equity? Let us make clear first that investors accept lower initial yields on shares than on fixed interest securities, for example gilts, because they expect their income and the capital value of the equities to rise. For example, if a buyer buys shares that could be bought at a price that offered 4% yield and the value of the shares rose...
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