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Governments of countries finance many of their activities - for example public and merit goods provision andor subsidisation - through borrowing from lenders by issuing bonds In the UK government bonds are known as gilt edged securities and are referred to as gilts Responsibility for them is managed by the Debt Management Office DMO which is an executive agency of the Treasury They advise on debt issues and organize the auctions of gilts on behalf of HM Treasury As with all forms of assets gilts pay a annual yield known as the coupon in the gilt edged market However the coupon isnt a perfect guide to the interest rate the Government had to pay when they issued the gilt because stocks are sometimes issued at a premium or discount o their par value The prices of gilts are determined primarily by interest rates but are also influenced by news and technical influences Firstly let us examine the effect of a change in interest rates on the price of gilts This is best explained by a theoretical case involving 3 different stocks1 Suppose that in 2001 the DMO decided to issue 3 stocks with the following details PriceIncome YieldRedemption Yield Short-dated 45 20031004545 Medium -dated 45 200101004545 Long -dated 45 20251004545 Suppose that a year later the UK economy has began to deteriate and that theres evidence of inflation growing and the US economy a major importer of our goods is slumping and investors are demanding higher yields to compensate If the DMO wanted to issue a new gilt at this point they would have to offer a yield of for example 6 to persuade investors to buy Its clear that investors wouldnt buy the 3 stocks above at a price of 100 and a redemption yield of 45 So what price would the investors buy the old stocks at The prices would have to fall in the market until they offer a 6
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