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In your example, the market's saying that $1200 in 10 years won't have the purchasing power of $1200. And the future purchasing power would be closer to $800 th
by unicornmama 4y ago
In your example, the market's saying that $1200 in 10 years won't have the purchasing power of $1200. And the future purchasing power would be closer to $800 than to $1000. Consider an alternative world where inflation is zero but you paid $1200 for a $1000-par bond.
The important concept here is the time value of money.
- twblalock 4y agoThis is not how investment losses or returns are calculated for accounting purposes, which is what matters when we talk about the solvency of a bank.
- acjacobson 4y agoThe price doesn't fall because the future purchasing power falls, the price falls because there are better alternatives in the market. No one will pay $1000 for a 2% return when they can pay $1000 for a 5% return. Market participants will always maximize their return. Bond prices adjust to be competitive or equivalent. But the govt. doesn't have this problem. They don't care about maximizing return - they care about containing contagion. So they can pay $1000 for a 2% return and not still not lose money over the long term.
- unicornmama 4y agoInflation strongly determines interest rates. You are getting 5% return because inflation expectations are high which caused the Fed to raise interest rates. When you see 5% risk free, you assume high inflation. The price falls because of the risk free rate, which is caused by high inflation, which causes drop in purchasing power.