Question

2) What are the consequences of raising interest rates for: a) bond markets b) stock markets

Answer 1

a)

Bond price and interest rates have inverse relationship. So increase in interest rate will decrease the bond price. This can be explained using the following example :

Suppose there is a zero coupon bond which is getting mature next year. Par value is $1000 and current value is $950

So this bond's 1 year return would be = (1000 - 950)/950 * 100 = 5.26%

For a person to pay $950 for this bond, he or she must be happy with receiving a 5.26% return as long as this rate is prevailing in the market. Let say interest rate in market is going to rise and new bond issue is giving 8% return/yield.

Now this person will not be happy and do not want to invest in the above mentioned bond. To make that bond equally attrative to the investor, its current price should decrease to a level where the return will become equals to current yield.

So price of the bond will decrease.

b)

When there is increase in interest rates, it does not directly affect the stock market itself. Increase in rates will make borrowing expensive. This in turn will have ripple effect which is explained below:

Because borrowing will become more expensive, Individuals will have to shell off more money for their credit card and mortgage etc. This will lead to decrease in disposable income for individuals. This means people will spend less discretionary money, which will affect businesses' revenues and profits and in turn their stock prices

Businesses are also affected directly by increase in interest rates because they also borrow money from banks to run and expand their operations. When the banks make borrowing more expensive, companies might not borrow as much and will pay higher rates of interest on their loans. Less business spending can slow the growth of a company; it might curtail expansion plans or new ventures, or even induce cutbacks. There might be a decrease in earnings as well, which, for a public company, usually means the stock price takes a hit.