Question

Provide a quantitative example, illustrating the effect of interest rates on bond pricing? As well, explain how the length of bond maturity and higher/lower coupon rates can affect bond prices when interest rates rise and fall in the economy.

Answer 1

Interest rates and prices of bonds are inversely related because it can be seen through their relationship which has been established as when the interest rates will be going up, the prices of bonds will be going down and when the interest rates will be going down,the bond prices will be going up.

Those bonds who are having a lower coupon are highly prone to higher interest rate, because when the interest rate will be going up, these bonds will be losing their attractiveness whereas those bonds who are offering a higher coupon rate are always preferred by the investors. hence it can be said that coupon rates and market interest are always comparable in nature as the bondholder will be comparing both in order to find out the effectiveness of Bond.

Bonds which are having a higher maturity period will be always vulnerable to the interest rate rise because those bonds which have a longer maturity will always be having a risk associated with change in their rate of return in the longer time and always those longer maturity bonds are more sensitive to the interest rate change higher than short term bonds.

Hence, it can be said that those bonds who are having the low coupon along with high maturity date will always have the high rate of sensitivity to change in any kind of interest rate.