As interest rates change the value of existing bonds go either up or down If interest rates increase the value of bonds sold at lower interest rates decline in value If interest rates decline the value of bonds sold at higher interest rates increase in value ID: 490153
Download Presentation The PPT/PDF document "The Relationship between Bond Prices and..." is the property of its rightful owner. Permission is granted to download and print the materials on this web site for personal, non-commercial use only, and to display it on your personal computer provided you do not modify the materials and that you retain all copyright notices contained in the materials. By downloading content from our website, you accept the terms of this agreement.
Slide1
The Relationship between Bond Prices and Interest Rates
As interest rates change, the value of existing bonds go either up or down.
If interest rates increase, the value of bonds sold at lower interest rates decline in value.
If interest rates decline, the value of bonds sold at higher interest rates increase in value.
Example: On September 1, 2012 you buy a $1000 Slide2
An Example
On September 1, 2012 you buy a $1,000 bond with a 10% coupon paid annually, with a two-year maturity.
This bond will pay you $50 interest at 6 months, another $50 interest at 12 months, another $50 at 18 months, and another $50, plus $1,000 at the end of month 24. Slide3
What Happens If Interest Rates Go Up before your Bond matures?
If you hold the bond until it matures, nothing. You will receive the interest payments and the principle as contracted.
However, if you want to sell the bond before it matures, you will have to sell it at a discount.
The reason is that buyers can now purchase bonds with a higher interest rate than the one you are receiving. Slide4
What Happens If Interest rates go down?
Again, as long as you are holding, nothing.
However, if you want to sell the bond before maturity, its value will have increased.
The reason is that your bond is paying better that new bonds. Slide5
How Do We Calculate these Values?
Let’s make an easy example.
We will use a Zero Coupon Bond.
With this type of bond you purchase it at a discount, hold it to maturity, and
at maturity you receive your original investment plus earned interest. Slide6
A Zero Coupon Bond
Let’s say you buy a bond with a face value of $1,000, with an interest rate of 10%, and a two year maturity.
How much should this bond cost?
P is the price you will pay
P (1.10) (1.10) = $1,000
P (1.1)2 = $1,000
P = 1000
_____
(1.1)2 = $826.00
If you pay this for the bond, when it matures at $1,000, you earned 10%. Slide7
If Interest rates change and you want to sell
Interest rates go up to 15%
P= 1000
__________
(1.15)2 = $756.00
Interest Rate goes down to 5%
P= 1000
____________
(1.05)2 = $907