Question

Raphael observes that at the current level of interest rates there is an excess supply of bonds, and therefore he anticipates an increase in the price of bonds. Is Raphael correct?

Short answer

An excess supply of bonds in the market will lower the bond's price.

Step-by-step solution

Introduction

The amount demanded of an asset is directly related to wealth, expected return on asset, and liquidity of the asset, and negatively proportional to expected return on alternative asset, liquidity of the alternative asset, according to the theory of portfolio choice.

Explanation

R made the observation that the supply of bonds has increased at the current level of interest rates, implying an increase in bond prices. R's prediction of a rise in bond prices is incorrect since it is based on the assumption that bond prices will rise owing to reduced interest rates and the market's supply of bonds will expand. However, according to portfolio theory, an excess supply of bonds in the market will lower the bond's price.