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Inter-temporal rate of substitution

Reading 55 - Economics and Investment Markets

Question about ITRS – the text  says that an investor is willing to pay less (i.e. ITRS is relatively lower) for a bond during good economic times. Can someone explain why?

My intuition is that ITRS should be relatively higher, since the marginal utility of consumption today is lower during good times, and ITRS = Marginal utility of consumption in the future/ Marginal utility of consumption today.

Thoughts??

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pastafarian wrote:
Reading 55 - Economics and Investment Markets

Question about ITRS – the text  says that an investor is willing to pay less (i.e. ITRS is relatively lower) for a bond during good economic times. Can someone explain why?

My intuition is that ITRS should be relatively higher, since the marginal utility of consumption today is lower during good times, and ITRS = Marginal utility of consumption in the future/ Marginal utility of consumption today.

Thoughts??

During good economic times, investors turn to stocks as they generate higher returns than bonds.  Stock prices rise, bond prices fall.

Laissez les bons temps rouler!

Simplify the complicated side; don't complify the simplicated side.

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Gotta separate the current state from the direction, and consumption from saving.

If you look only at the present, and times are bad, you will get a lot of pleasure from a little more. If you’re starving, buying a sandwich is massively satisfying. But if times are good and you buy your 6th umbrella – less “wow”. So, good times = low marginal utility of consumption now. Bad times = high marginal utility of consumption now.

If the economy is okay now, but you expect it will be terrible in the future, you’ll save for the rainy day by consuming less now – you’ll transfer “not consumption” to your future self. Your ITSR is thus high (because you’re like, “I will be starving next year so I should substitute consumption now on an intertemporal basis”). But if things are okay now and you expect them to be very good in the future – well, “Don’t Worry Be Happy!” Why save when you can drive Bentleys off piers, and live even larger in the golden age ahead. Your ITSL is very low (because you’re too coked out to pronounce “intertemporal”).

Now, buying a bond is not buying food. It’s the opposite. If you expect a dark age ahead, you want to transfer money to your future starving self (your ITSL is high) – you have to buy a bond and give up an extra sandwich. But if you expect a future in which unlimited robot butlers give free ass massages and no one wants for anything – well, sell all your bonds and buy a 12 million boxes of cinnamon toast crunch. And a Bentley.

I.e., during good economic times, and when you expect better economic times in the future, you spend more, save less, and thus are less keen on overpaying for a bond.

Remember the mathematics!

ITRS = u1 / u0

Where u1 is the marginal utility of consuming in the future and u0 is the marginal utility of consuming today.

u0 is always higher than u1 except when economic enviroment is extremely bad (1929 for example, even 2008)

In good economic times or when good economic times are expected to come soon the marginal utility of consuming in the future gets lower because we prefer to consume today. So u1 decreases and u0 increases giving a new ITRS lower than before.

Also remember how the real risk-free rate is built from the IRTS:

Rf = (1 / IRTS) -1

Rf and IRTS are negatively related, so when IRTS decreases (good economic enviroment) the real risk-free rate gets higher. This plays exact with what TheMagician said: “in good economic times, investors prefer to invest in equity and less in bonds, bond prices get lower”. Lower bond prices give what? Yup, higher rates. Everything is chained.

Hope this helps.

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Excellent explanation. Thanks to you and thanks to the magician also for his french sentence putting a pure light on a difficult concept to grasp for a simple french guy like me.

FloFromParis wrote:
[T]hanks to the magician also for his french sentence putting a pure light on a difficult concept to grasp for a simple french guy like me.

D’accord.

Simplify the complicated side; don't complify the simplicated side.

Financial Exam Help 123: The place to get help for the CFA® exams
http://financialexamhelp123.com/

FloFromParis wrote:

Excellent explanation. Thanks to you…

I assume this is for me (hope so).

Thanks for your gratitude, indeed. laugh

Las almas de todos los hombres son inmortales, pero las almas de los justos son inmortales y divinas.
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You are welcome.