# Indian Financial Services

Why do bond prices vary inversely with the interest rate?

Amandeep Singh Roll Number # 05 Section FN 4 IIPM

Bonds in India
 Interest rate
± Generally fixed ± Known to investors

 Principal of a bond / Bond with maturity  Payable after a specified period ( Maturity period )

Features of bonds
 Face Value :
± Also called par value ± The value at which bonds are issued ± Generally multiples of 100 or 1000

 Interest Rate:
± ± ± ± Also called coupon rate Fixed Tax deductible Known to holders (Bond Holders / Debenture Holders )

Features of bonds
 Maturity:
± Issued for specified period called maturity period ± Repaid on maturity

 Redemption Value:
± Value bondholder gets on maturity ± Also called maturity value

Features of bonds
 Market Value:
± Bond may be traded in stock market ± The value of trade is called market value ± May or may not be different from par / redemption value

Kinds of bonds
 Bonds with maturity  Pure discount bonds  Perpetual Bonds

Bonds with maturity
 PV of a bond = Discounted value of cash flows + PV of bond¶s maturity value  PV > Market Value ( Undervalued )  PV < Market Value ( Overvalued )  Pre-specified interest rate ( coupon rate )  Pre-specified maturity period

Bonds with maturity
   


Par Value : 1000 Interest Rate : 7% pa ( 70 pa ) Required Rate : 8% What must be paid now if bond matures at par?
B0 = [70/(1.08)]+[70/(1.08)2]+[70/(1.08)3]+[70/(1.08)4]+[1000/(1.08)5]=960.51

 If current rate is less than 960.51 buy , else don¶t
 *B0 = [INT1/(1+kd)]+[INT2/(1+kd)2]+«+[INTn/(1+kd)n]+Bn/(1+kd)n

Pure Discount Bonds
 Don¶t carry explicit rate of interest  Provides for payment of lump sum amount at future date in exchange for a the current price  Face Value = 1000 , Market Value = 520  Period = 5 Years  500 = 1000/(1+YTM)5  Hence YTM = 14%

Example
 10% , Rs. 1000 bond with no maturity
Interest Rate decreases bond value increases Interest Rate decreases bond value increases Discount Rate 5 10 15 20 25 30 Value Of Bond 2000 1000 667 500 400 333

Bond Value Interest Rates
 Value of bond 1/Interest Rate  Value of bond declines as the market rate increases.  Bond value decreases with rising rate of interests rate since the cash flows associated with bond decreases.  Bond holders have interest rate risk

Inference
Hence the above example proves that the bond prices vary inversely with the interest rate.