Bond Pricing the Most Fundamental Research Proposal

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For example, if the Fed sees inflation as a risk going forward, the market will place a weighting on that statement, allocating some form of increased interest rate to the future cash flows.

At the time of course, the exact implications of the Fed's comments are unknown. They imply that rates may move in one direction or another, but they are not an actual movement and the Fed reserves the right to change its mind before it meets again. The bond market is thus working with imperfect information. This can lead to general price movements but of unknown quantity. Over time, a reasonable correlation can be established, such as the elasticity of bond prices in relation to, for example, strong warnings from the Fed about inflation. Such a correlation can be drawn with a large enough sample size that it can be used in bond prices.

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Overall, though, the exercise still involves guesswork. Bond prices directly reflect prevailing interest and inflation rates because the time value of the known future cash flows is impacted. According to efficient market theory, bond prices will reflect all known information with respect to inflation rates and the Fed's response to those rates. Clearly the bond market in practice considers the non-numerical Fed statement as information as well. This does not imply irrationality as different investors may reasonably draw different conclusions from the often-cryptic statements. Bond prices therefore represent not only known financial information but expectations of future financial information regarding inflation and interest rates, as interpreted from the Fed statements and the macroeconomic data that contribute to the market's understanding of the future inflation and interest rate changes.

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