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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

2036 words - 9 pages

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 ...view middle of the document...

The new yields and prices expected are shown in the table below:Price Income Yield Redemption YieldShort-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 in value by 6% over the year. The overall return to the buyer would be 10%. This could be attractive relative to the 6.5% return that might be offered on gilts. This additional 3.5% allows for the greater risk element in shares.Let us take an example and assume that prices of gilts fall so sharply that the yields on the stocks rise to 10%. Investors would certainly want a greater return than the 10% on equities to allow for the risk element. Thus, in the short-run this higher yield can only be achieved by the price of the equity in the market falling - I.e. the investor is paying a lower price for the same dividend, so the yield to the buyer has risen. The reverse would happen if the value of gilts rose sharply.But the issue isn't as simple because interest rate changes affect different companies differently. For example, a rise in interest rates is likely to be unfavourable to construction companies of house, e.g. Wimpey Homes, because it raises the cost of mortgages and...

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