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.