Price level and interest rate relationship with bonds

Relationship between bond prices and interest rates (video) | Khan Academy

price level and interest rate relationship with bonds

interest rates and bond prices move in opposite directions—for example, when bonds. (Many bonds pay a fixed rate of interest throughout their term; interest is to provide investors with a better understanding of the relationship among. Bond prices decrease when interest rates increase because the fixed interest and principal payments stated in the bond will become less attractive to investors. At first glance, the inverse relationship between interest rates and bond prices seems somewhat illogical, but upon closer examination, it makes.

Let me do it in a different color. Let me draw a little timeline right here. This is two years in the future when the bond matures, so that is 24 months in the future.

price level and interest rate relationship with bonds

Halfway is 12 months, then this is 18 months, and this right here is six months. Now, the day that this, let's say this is today that we're talking about the bond is issued, and you look at that and you say, you know what? Now, let's say that the moment after you buy that bond, just to make things a little bit Obviously, interest rates don't move this quickly, but let's say the moment after you buy that bond, or maybe to be a little bit more realistic, let's say the very next day, interest rates go up.

If interest rates go up, let me do this in a new color. Obviously for something less risky, you would expect less interest. Interest rates have gone up. Now, let's say you need cash and you come to me and you say, "Hey, Sal, are you willing to buy "this certificate off of me? I'll actually do the math with a simpler bond than one that pays coupons right after this, but I just want to give the intuitive sense.

Or you could just essentially say that the bond would be trading at a discount to par. Bond would trade at a discount, at a discount to par. Now, let's say the opposite happens.

Let's say that interest rates go down. Let's say that we're in a situation where interest rates, interest rates go down.

So how much could you sell this bond for? I'm not being precise with the math. I really just want to give you the gist of it. So now, I would pay more than par. Or, you would say that this bond is trading at a premium, a premium to par.

So at least in the gut sense, when interest rates went up, people expect more from the bond.

The Relationship Between Bonds and Interest Rates

This bond isn't giving more, so the price will go down. Likewise, if interest rates go down, this bond is getting more than what people's expectations are, so people are willing to pay more for that bond.

price level and interest rate relationship with bonds

Now let's actually do it with an actual, let's actually do the math to figure out the actual price that someone, a rational person would be willing to pay for a bond given what happens to interest rates.

And to do this, I'm going to do what's called a zero-coupon bond.

price level and interest rate relationship with bonds

I'm going to show you zero-coupon bond. Actually, the math is much simpler on this because you don't have to do it for all of the different coupons. You just have to look at the final payment. There is no coupon. So if I were to draw a payout diagram, it would just look like this. This is one year.

Bonds, Interest Rates and the Impact of Inflation - Business in Greater Gainesville

This is two years. Now let's say on day one, interest rates for a company like company A, this is company A's bonds, so this is starting off, so day one, day one. The way to think about it is let's P in this I'm going to do a little bit of math now, but hopefully it won't be too bad.

Inflation and interest rates behave similarly to bond yields, moving in the opposite direction from bond prices. If inflation means higher prices, why do bond prices drop? The answer has to do with the relative value of the interest that a specific bond pays. Rising prices over time reduce the purchasing power of each interest payment a bond makes. Why watch the Fed?

Inflation also affects interest rates. The Fed takes an active role in trying to prevent inflation from spiraling out of control.

price level and interest rate relationship with bonds

When the Fed gets concerned that the rate of inflation is rising, it may decide to raise interest rates. To try to slow the economy by making it more expensive to borrow money. For example, when interest rates on mortgages go up, fewer people can afford to buy homes. That tends to dampen the housing market, which in turn can affect the economy. When the Fed raises its target interest rate, other interest rates and bond yields typically rise as well.

New bonds paying higher interest rates mean existing bonds with lower rates are less valuable. Prices of existing bonds fall. An overheated economy can lead to inflation, and investors begin to worry that the Fed may have to raise interest rates, which would hurt bond prices even though yields are higher.

When rates are dropping, bonds issued today will typically pay a lower interest rate than similar bonds issued when rates were higher. Those older bonds with higher yields become more valuable to investors, who are willing to pay a higher price to get that greater income stream. As a result, prices for existing bonds with higher interest rates tend to rise. Three years later, she wants to sell the bond. That may or may not be good for bonds. Bond prices may go up. However, a slowing economy also increases the chance that some borrowers may default on their bonds.