One of the most important lessons in interest rates and bond valuations is their
ID: 2671444 • Letter: O
Question
One of the most important lessons in interest rates and bond valuations is their inverse relationship. It is absolutely critical that bond investors understand the many effects of that relationship on the day-to-day valuation of bonds.To that end, given the following situations, note the whether the price of the bond would a) increase, b) decrease, or c) stay the same, or d) no-impact given the situations noted below, and a brief explanation for your rationale.
Interest rates rise given a $1000 zero coupon bond
Interest rates decline given a $1000 bond paying 2% semi-annually
Interest rates rise given a $1000 bond paying 6% annually with 7 years remaining to maturity.
Explanation / Answer
There is always a inverse relationship between the interest rates and the valuation of the bond and it is also very necessary for the investor to understand the relationship between the interest rates and the price of the bond in a day to day life. When the interest rate rise of a $1000zero coupon bond the price will remain the same because it is a zero coupon bond and as a result there will be no change in the price. Interest rates decline given a $1000 bond paying 2% semi-annually; when the interest rate declines its price will increase because the market rate is less than the stated rate and as a result of it its price will rise because there is inverse relationship between the price and interest. Interest rates rise given a $1000 bond paying 6% annually with 7 years remaining to maturity; when the interest rates rise then the price of the bond will decline because the market rate is more than the stated rate and the period of maturity is also longer. Therefore the price of the bond will decline and the investor of the longer period maturity bond will not be happy because he will receive less interest than he is expecting.
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