1.

Wealth
2. Expected Return
3. Risk
4. Liquidity

Asset a piece of property that is a store of value
Pearson Prentice Hall Financial Markets and Institutions 4 - 1
Determinants of Asset Demand



1. Wealth - total resources owned, including all assets
2. Expected Return - return expected over the next
period) on one asset relative to alternative assets
3. Risk - degree of uncertainty associated with the return
4. Liquidity - the ease & speed with which an asset can be
turned into cash


Pearson Prentice Hall Financial Markets and Institutions 4 - 2
Determinants of Asset Demand


Ceteris paribus -
1.Wealth - an increase in wealth raises the quantity demanded
of an asset
2.Expected Return - weighted average of all possible
returns, where the weights are the probabilities of
occurrence of that return: R
e
= p
1
R
1
+ p
2
R
2
+. . . + p
n
R
n

an increase in an assets expected return relative to that
of an alternative asset, raises the quantity demanded of
the asset



Pearson Prentice Hall Financial Markets and Institutions 4 - 3
Determinants of Asset Demand


Ceteris paribus
3.Risk - the degree of uncertainty associated with the return;
a measure of risk called the standard deviation (). The
standard deviation of returns on an asset is calculated as:
Square root of the weighted squared deviations from
the expected return (R
e
)
= p
1
(R
1
- R
e
)
2
+ p
2
(R
2
- R
e
)
2
+. . . +p
n
(R
n
- R
e
)
2

if an assets risk RISES relative to that of alternative
assets, its quantity demanded will FALL
Pearson Prentice Hall Financial Markets and Institutions 4 - 4
Determinants of Asset Demand


Ceteris paribus
4.Liquidity - the ease and speed with which an asset can be
turned into cash
An asset is liquid if the market in which it is traded has depth
and breadth, i.e., if the market has many buyers and sellers
Treasury bill - a highly liquid asset; well-organized market
The more liquid an asset is relative to alternative
assets, the more desirable it is, and the greater will be
the quantity demanded
Pearson Prentice Hall Financial Markets and Institutions 4 - 5
Determinants of Asset Demand


Summary response:
Change in Change in
Variable Quantity Demanded

1. Wealth h h
2. Expected Return h h
3. Risk h i
4. Liquidity h h


Pearson Prentice Hall Financial Markets and Institutions 4 - 6
Determinants of Asset Demand





Example:
1-yr Discount Bond,
Face vale, $1000
Holding Pd: 1 yr
R
e
= i = F P
P


Pearson Prentice Hall Financial Markets and Institutions 4 - 7
Demand & Supply Curves
Equilibrium Pt



Demand Curve B
d
: downward slope, indicating that at
LOWER prices of the bond, ceteris paribus, the quantity
demanded is HIGHER

Supply Curve B
s
: upward slope, indicating that as the price
increases, ceteris paribus, the quantity supplied is INCREASES

Market Equilibrium : Quantity Demanded = Quantity Supplied
or Market-Clearing Price B
d
= B
s

Pearson Prentice Hall Financial Markets and Institutions 4 - 8
Demand & Supply Curves




Market Implications
When the PRICE of bonds is set too HIGH: B
s
>

B
d
: Excess B
s

people want to SELL more bonds than others want to buy,
the price of the bonds will FALL;
as long as price is above equilibrium, it will continue to fall
When the PRICE of bonds is set too LOW: B
s
<

B
d
: Excess B
d
people want to BUY more bonds than others want to sell,
the price of the bonds will BE DRIVEN UP;
as long as price is below equilibrium, it will continue to rise

Pearson Prentice Hall Financial Markets and Institutions 4 - 9
Demand & Supply Curves



Movements along the Curve vs Shifts in the Curve
ALONG the Curve:
rQty due to rPRICE or rInterest Rate (i)
SHIFT in the Curve:
r Qty at each given PRICE or Interest Rate
- in response to r in some factors beside PRICE or i


Pearson Prentice Hall Financial Markets and Institutions 4 - 10
Changes in Equilibrium Interest Rates



Shifts in the Demand for Bonds
1. Wealth
2. Expected returns on bonds relative to alternative
assets
3. Risk of bonds relative to alternative assets
4. Liquidity of bonds relative to alternative assets


Pearson Prentice Hall Financial Markets and Institutions 4 - 11
Changes in Equilibrium Interest Rates


If h, h
Economy is growing rapidly,
expansion & wealth is
increasing, the demand curve
shifts to the RIGHT;
Recession: income & wealth
are falling, the demand for
bonds falls, and the demand
curve shifts to the LEFT.
Pearson Prentice Hall Financial Markets and Institutions 4 - 12
Changes in Equilibrium Interest Rates
Shifts in the Demand for Bonds: WEALTH





If h, i
Higher expected interest
rates in the future i the
expected return for LT bonds,
ithe

B
d
, and shift the curve to
the LEFT;
Lower expected interest
rates: RIGHT.
Pearson Prentice Hall Financial Markets and Institutions 4 - 13
Changes in Equilibrium Interest Rates
Shifts in the Demand for Bonds: Expected Returns





If h, i
Higher expected inflation
rates in the future i the
expected return for LT bonds,
ithe

B
d
, and shift the curve to
the LEFT;
Lower expected inflation
rates: RIGHT.
Pearson Prentice Hall Financial Markets and Institutions 4 - 14
Changes in Equilibrium Interest Rates
Shifts in the Demand for Bonds: Expected Inflation





If h, i

Increase in riskiness i the
bonds become less attractive,
ithe

B
d
, and shift the curve to
the LEFT;

Pearson Prentice Hall Financial Markets and Institutions 4 - 15
Changes in Equilibrium Interest Rates
Shifts in the Demand for Bonds: RISK





If h, h
More people started trading in
the bond market, and as a result
it became easier to sell bonds
quickly; hliquidity of bonds
results in an hB
d
, the demand
curve shifts to the RIGHT;
hliquidity of ALTERNATIVE
ASSETS iB
d
, shifts the demand
curve to the LEFT.
Pearson Prentice Hall Financial Markets and Institutions 4 - 16
Changes in Equilibrium Interest Rates
Shifts in the Demand for Bonds: LIQUIDITY






Shifts in the Supply for Bonds
1. Expected profitability of investment opportunities
2. Expected inflation
3. Government budget

Pearson Prentice Hall Financial Markets and Institutions 4 - 17
Changes in Equilibrium Interest Rates


If h, h
Economy is growing rapidly,
business cycle expansion, B
s
is
increasing, the supply curve
shifts to the RIGHT;
Recession: fewer expected
profitable investment
opportunities, and the supply
curve shifts to the LEFT.

Pearson Prentice Hall Financial Markets and Institutions 4 - 18
Changes in Equilibrium Interest Rates
Shifts in the Supply for Bonds: PROFITABILITY





If h, h
Real cost of borrowing i,
business cycle expansion, B
s
is
increasing, the supply curve
shifts to the RIGHT
FISHER EFFECT:
When expected inflation
rises, interest rates will rise
Pearson Prentice Hall Financial Markets and Institutions 4 - 19
Changes in Equilibrium Interest Rates
Shifts in the Supply for Bonds: Expected Inflation





If h, h
Deficit: Government borrows
by issuing Treasury Bonds, B
s

is increasing, the supply curve
shifts to the RIGHT;
Surplus: supply curve shifts to
the LEFT.

Pearson Prentice Hall Financial Markets and Institutions 4 - 20
Changes in Equilibrium Interest Rates
Shifts in the Supply for Bonds: GOVERNMENT BUDGET






Analysis assumptions:
1. Examine the effect of a variable change, remember that
we are assuming that all other variables are unchanged;
that is, we are making use of the ceteris paribus
assumption
2. INTEREST RATE is negatively related to the BOND PRICE,
so when the equilibrium bond price rises, the equilibrium
interest rate falls. Conversely, if the equilibrium bond
price moves downward, the equilibrium interest rate
rises.
Pearson Prentice Hall Financial Markets and Institutions 4 - 21
Changes in Equilibrium Interest Rates