Q4. Assume that the market for the bond is perfect and competitive. Say there is a one-year maturity bond that has a rate of return 10% while the market interest rate is 8%. Further assume that the one-year maturity bond is risk free. What will happen in this market? (9 People will borrow money at 8% interest rate and buy the bond. After 1 year, people will pay back what they borrowed but still have some profit left. This will continue until the increase in demand of the bond will increase the price of the bond, which will decrease the rate of return of bond to 8%. People who have that bond will want to sell it. lfthey do not have the bond, they will short sell it, meaning that they will promise to sell in the future while they do not have it now. As they earn money by selling, they will invest in another asset that gives 8% interest rate or save it in the bank that gives 8% interest rate. This selling continues and the price of bond will decrease, which will lead to an increase of the rate of return of the bond. People will borrow money at 8% interest rate and buy the bond. After 1 year, people will pay back what they borrowed but still have some profit left. This will continue until the increase in demand of the bond will increase the price of the bond, which will increase the rate of return of bond. @ People who have that bond will want to sell it. lfthey do not have the bond, they will short sell it, meaning that they will promise to sell in the future while they do not have it now. As they earn money by selling, they will invest in another asset that gives 8% interest rate or save it in the bank that gives 8% interest rate. This selling continues and the price of bond will decrease, which will lead to a decrease of the rate of return of the bond to 8%