Market Demand and Supply

We all learned in our economics classes that the way to think about the price of anything is through the forces of demand and supply. That's how market economies are supposed to work—at least when there are no government price controls or other impediments to the free flow of goods and services. The market-clearing price will be such that demand equals supply, that is, where the two curves cross in the classic economics diagram. We'll soon use those diagrams to determine the level of bond prices and yields.

Consider first Figure 3.1 illustrating a bond transaction. To force this example a bit, suppose there is only one specific bond that can be bought or sold—a 4%, annual payment, 4-year fixed-income security. On the ...

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