Question

Interest rates play a prominent role in calculation, and determination of bond prices, and yields. Let's discuss why, and what factors need to be addressed with this. Use examples.

In addition, let's not forget what factors affect the valuation of common stock. Use examples.

Answer 1

Interest rates plays a prominent role in the determination of bond prices as well as yields, interest payments is basically the amount that a individual pays for the use of other's money and therefore if the rate of interest will be higher the use of money will become more expensive. There is a inverse relationship between bond prices and interest rates. If the rate of interest go down, the bond prices will go up and vice versa. A bond comes up with a periodic payment which is call coupon payment. This coupon payment is reflected in terms of rate of interest. The role of interest rate in determining the bond prices is based on the concept of opportunity cost, investor continuously compares the rate of return they will get elsewhere with what they are getting currently and this will make their current investment look either desirable or undesirable and thus investors are then ready to pay more or less for the same bond, which leads to fluctuation in prices.

For example, if an individual buy a $1,000 bond with a coupon rate of 6%. Now the interest rate goes up, and a new bond with same price of $1,000 is offering a rate of 8%. Hence the previous investment becomes undesirable and the investor would want 8% return. Now the investor would like to sell the previous bond, but in order to sell it to other person, he will have to sell it at a lower price than $1,000 so that the effective return to the new investor will be 8% which prevalent right now.

Some other factors that affects bonds prices are credit rating of the borrower, state of the economy, prevalent interest rate in the economy and the overall sentiments of the investors.

In terms of stock, there is no direct impact of interest rate changes in stock valuation but it can have a long term indirect effect on the stock valuation. Higher interest rate means credit becomes expensive and businesses will not have enough money to fund their project, thus leading to low profits and a low EPS in general. It also affects the purchasing power of consumers and therefore a slowdown in the demand can be witnessed with higher rate of interest. There are various other factors which affects the valuation of common stock like management expertise, business growth, profitability, state of the economy, interest rate demand and supply situation for the business etc.