Zero Coupon Bond Is One Thesis

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3. When the expected rate of inflation changes, the expectations for future interest rates also change. An increase in inflation will bring an increase in interest rates, all things being equal. In such a situation, bond prices will go down. If the expected rate of inflation drops, bond prices will increase in anticipation of a potential interest rate cut. The intensity of the price change will depend on the maturity of the bond. Part of the bond's price is determined by its time value, which is the risk of an adverse change in interest rates. Longer bonds have greater interest rate risk, therefore they are subject to more intense changes as a result of changes in the expected inflation rate.

One outcome of this is a change in the yield curve. If inflation is expected to drop, bond prices will increase. This will reduce the yields. Because the long end of the curve has sharper reactions to such changes, it could end up dropping below the front end. This is what is known as an inverted yield curve.

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It is a predictor of recession because when interest rates drop too quickly, that is correlated with a decrease in economic activity.

4. Duration is the sensitivity of a bond to interest rate changes. In general, duration increases with time to maturity, but is always less than the remaining time to maturity of the bond. Duration is important for measuring the interest rate risk of the portfolio. Investors often have the choice between bonds of similar maturity, but those seeking to lower interest rate risk would choose the one with the lowest duration (Liu, 2006). The market value of the bond portfolio is influenced by the degree of interest rate risk, so this is often an important consideration for investors and investment advisers.

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