Question

When bond prices go up, interest rates ___________.

a) remain constant

b) decrease

c) increase

Answer 1

The bond price and interest rates are inversely related. If the market rate of interest falls, the bond price increase and if the market rate of interest increase bond price decrease. The investors in bonds usually compare the yield from the bonds on maturity and the amount that they could get in other investment opportunities. For example if a company issues new bond with a coupon rate of 8%. It means that the yearly yield of the bond having value equal to $1000 is $8. Suppose the interest rate increase to 10% the new bonds will be issued at a coupon rate of 10%.Thus the yield on the bond having value of $1000 is $10. Then the buyer will not be ready to buy the old bond having a coupon rate of 8% per annum. In order to sell this bond sellers have to offer a low price for the previous bonds. In other words the old bonds will be sold at a discount on its par value. In this way when the rate of interest increases the bond price falls. On the opposite case when the rate of interest falls the prior issued bonds will be more attractive to buy because the yield from such bonds is higher than the market rate of interest. These bonds will be sold at a rate higher than the par value.

Answer: b. Decrease.