TOPIC: Interest Rates, Business Decisions, and Bond Valuation

SOURCE: "The Zero Inflation Economy," Business Week, January 19,1998, pages 28-31.

SYNOPSIS: One of the major determinants of nominal interest rates is the expected rate of inflation. This article documents the extremely low inflation rate we are currently experiencing in the U.S. economy and explains its impact on corporate sales and profits. It also describes the potential for international competitors to become more competitive, especially for commodity producers. A related article, "Wall Street: No More Easy Street," (page 32) provides more insight into which industries stand to gain or lose in a zero inflation environment.

DISCUSSION QUESTIONS:

1. In July 1996, long-term U.S. Government bonds were priced to yield an interest rate of 7.1%. According to the article, how has this rate changed? Use Equation 4-1 on page 127 to articulate the reasons for these changes.

2. According to the article, why is low inflation good news for some firms, but bad for others? How does the strong (zero inflation) dollar influence international competition?

3. Suppose the U.S. Government issued two bonds last year. Both sold at a price equal to its par value of $1,000. Bond A was a 30-year bond paying a 7.1% annual coupon. Bond B was a 10-year bond also paying a 7.1% annual coupon. Now both bonds are priced to yield 5.8%. Determine the current price for each bond. Which bond appears to have more interest rate risk?