Answer to Question #259293 in Macroeconomics for AD32

Question

3. If inflation rises, why is a bond more likely to be sold at a discount to its face value? Explain, with reference to the bond’s coupon. (10%)

4. Using a supply and demand diagram, carefully explain how the January 2021 ‘short squeeze’ of GameStop (GME) caused its share price to rise dramatically. (10%)

Answer 1

a.Most bonds are fixed whereby the interest paid never changes over the life of the bond. Bondholders will get the interest rate- coupon rate- of the bond always no matter how the interest rates change.When inflation increases, new bonds entering the market are issued at higher interest rates, which increases their yields.So when interest rates rise, investors are demanding higher yields from bonds they are considering buying. If you expect interest rates to continue rising in the future, you don't want fixed-rate bonds with current rates. As a result, the secondary market price of older, lower-yielding bonds declines. Therefore, these bonds are being sold at a discount.

b.As of January 13 to 29, an average of about 100 million GME shares were traded per day, an increase of more than 1,400% from the 2020 average.There were short sellers in it that covered their position, but they were far from most of them.The demand may have been caused by buyers being driven by a belief in GameStop fundamentals or a desire to press short selling to profit from the resulting price increase.