Question

In: Finance

Explain why bond prices fluctuate in response to changing interest rates. What adverse effect might occur...

Explain why bond prices fluctuate in response to changing interest rates. What adverse effect might occur if bond prices remain fixed prior to their maturity?

Solutions

Expert Solution

a.

Bonds price is inversely related to interest rates. Bond pays fixed coupon during life of bond and at maturity it pays coupon plus principal or par value. As the bond has fixed cash flow we can calculate the price of the bond based on current interests and these current interest rate keeps on fluctuating. Basically, current interest rates are used as discounting factor to value the stream of cash flows. Hence, if we sum all present values we would get price of bond.

If the current interest rates are higher than the coupon rate then the bonds prices will be lower than par value because interest rates are discounting factors and which result in lower present values. If the current interest rates are lower than the coupon rate then prices will be higher than par value. This is how the bond price fluctuates in response to current interest rates.

b.

If bond prices remain fixed then it means they are not responding to changing interest rates. Investors who trade in bonds prior to its maturity, they would not like to buy any financial instruments which doesn’t fluctuates because investors would have not interest in such instruments which has no time value of money application. As a result, there would arise a problem of having bond investors.


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