Tuesday, August 30, 2011

Quick note on government bonds

I am reading a book by Niall Ferguson titled " Ascent of Money". The book so far has been a bit of a disappointment, but still I have learned quite a bit about government bonds and general topics related to financing. Again this a posting that is more of mental note for myself. The majority of the material here is from Ferguson's book. I've made the illustrations myself and condensed and added some ideas of my own.

Basics of how government bonds work

In this section I'll try and explain what government bonds are and how they work as I understand them. These days virtually every government needs to borrow money from the market. In the early days government bonds where used to collect money to pay for wars but today they are used to finance government expenditure.

The basic idea behind a government bond is that the state sells a piece of paper with nominal value of 5000 and promises to pay 5% interest(paid from the nominal value) per annum for the next 10 years to the holder of the bond. This means that the buyer can sell the bonds at market price if faced with a acute need of money or if the owner sees that the money can make better profit when invested differently.

The concept of effective interest is something worth discussing. It is calculated like this:

What this means that if you purchase a bond from after market at price of 4500 the effective interest rate is higher than the one marked on the bond. But there is catch. As we all know there is no such thing as a free lunch. Why has the market price of of Brutopias 10 year bond declined? Well it means that the consensus on the market is that Brutopias ability to take care of it's debts has decreased. This means that investors may not get their money at the end of the ten year loan time, or the payment might be delayed.

This means that really big profits can be made when the governments financial situation is some compromised. Also when investing to government bonds of foreign nation you must take into account the changes in exchange rates and the inflation rate in that country as it may quite quickly eat up any profit you expect to make.

In general government bonds are safe investments as it is usually quite impossible for country to go bankrupt, because it can always tax it's citizens. However the profits are not that big either. 

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