Question

explain why the price of a bond and in the interest earned on the holding of a bond must move opposite direction.

Answer 1

The price of bond changes in response to changes in interest rates in the economy. Interest rates and bond prices have an inverse relation. To understand this concept, lets take example of a zero coupon bond.

A zero coupon bond is a bond issued at a deep discount but pays no interest. It is actually issued at price that will match the interest upon maturity. For eg a zero coupon bond trading at $ 960 and has a par value of $ 1000 means it has an inherent interest of $ 40 i.e. $40/960 = 4.17% interest. Now if the interest rate in the economy rises to 6%, the bond will be resulting in lower interest rates and people will start selling it, unit it reaches the market rate of 6% which in this case will be 943.40 (1000 x 106/100) i.e. it will give 6% return then.

Assuming, the same interest rates all through out the period, when the bond is issued it is farthest to its par value and while approaching the maturity as the interest component reduces, the price will be closer to the par value.