Financial Assets (AQA A Level Economics): Revision Note

The Difference Between Debt & Equity

• Debt is a liability; it represents what firms owe

  • Individuals or businesses that lend money to a firm are called creditors

  • E.g. Banks loans, corporate bonds, and mortgages

• Equity represents all physical and financial assets owned by firm

  • Firms can raise finance by issuing shares or corporate bonds

• Firms can use both debt and equity as a source of finance for their operations
   

The Difference Between Debt and Equity as a Source of Finance

The Relationship Between Interest Rates & Bond Prices

Key terminology in the bond market

• Market interest rates (also known as yields) are the cost of borrowing money or the return on savings

• Bond prices are the amount investors are willing to pay for government bonds

  • Governments and big companies issue bonds to raise funds for various purposes, like covering a government's budget deficit or allowing a company to invest in new equipment

Nominal Value, Coupon and Maturity of Bonds

Interest rates, bond prices and secondary markets

• Before a bond reaches maturity, it can be resold in secondary markets

• Investors can buy or sell them at prices different from the nominal value 

  • E.g. Market price is £1,100 compared to nominal value of £1,000

• Market prices for bonds vary in the secondary market due to market forces
  

  • If the interest on bonds is high relative to other returns on investment, demand for bonds increases

    • The lower the demand for bonds, the lower the market price

Diagram: The Relationship Between Interest Rates and Bond Prices

• Market forces cause interest rates to vary 

  • If government issues a bond this year with 5% interest, they may have to issue bonds with 7% interest next year due to market forces

  • The interest rate on each bond is fixed 

• 5% bonds now have a less attractive return on investment in the secondary market 

  • E.g, They have a 2% lower return compared to new bonds issued 

  • Existing bonds will be less attractive to investors 

  • As a result, demand falls for existing bonds, causing price of bonds to fall

• The opposite will also be true. If the government issues new bonds at a lower interest rate, then the demand for existing bonds will increase 

  • If government issued a bond last year at 5%, they may have to issue bonds at 3% this year

  • Existing bonds will be more attractive to investors than the new bonds 

  • As a result, demand for existing bonds rises, causing the price to rise

  • The new bond price may fall relatively quickly in the secondary market

• Therefore, long-run rate of interest and yields have an inverse relationship with government bonds prices

  • As interest rates rise, bond prices fall 

  • As interest rates fall, bond prices rise