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IAI Actuarial Core Principles · Business Economics · Role of money and interest rates in the economy

A bond pays a fixed perpetual coupon of ₹80 a year. Market yields are 8%, so the price is ₹1,000. Investors then expect yields to rise to 10%. According to the speculative motive, what is the expected price and the likely response?

The expected price is ₹800 (80 divided by 0.10), a capital loss of ₹200 against only ₹80 of annual interest. Investors therefore expect to lose on bonds and shift into money balances, raising speculative demand for money.

  1. AExpected price ₹800; investors shift out of bonds into money balancesCorrect
  2. BExpected price ₹800; investors buy more bonds
  3. CExpected price ₹1,250; investors shift out of bonds into money
  4. DExpected price ₹1,250; investors buy more bonds
  5. Expected price ₹1,000; no change in behaviour

Explanation

The perpetuity price equals coupon divided by yield, so 80/0.10 = ₹800. This is a capital loss of ₹200 on a bond bought at ₹1,000, which exceeds the ₹80 annual interest. Investors therefore prefer to hold money, increasing speculative money demand. The ₹1,250 price comes from wrongly using the 8% yield on the 10% base.

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