Case Study where there is fluctuation in Interest on Higher side: –
Now, if the market rate of interest fluctuates then there are only two possibilities, either market rates will be higher than coupon or lower than coupon. Take a case if market rates are higher than the coupon. For example B lends Rs. 100 to A @ 8% and if interest rate goes up, B would not have opportunity to encash the higher cash flows, as his money is already blocked with A. He could have lent the same amount to other person with higher interest rate and get higher future cash flows. To understand this concept better, consider that market rates rises to 9%.
Face Value: 100
Market Rate: 9%
Years 0 1 2 3 -100
PV1 7.34 8 FV1
PV2 6.73 8 FV2
PV3 83.40 FV3
In the above table, considering the same example of Bond paper issued by A of face value Rs. 100/- @ 8% for three years, where B will get the future cash flows of 8, 8 and 108 in three years respectively. If interest rates increases to 9%, then we can see that the present values of respective cash flows are reduced, resulting in the reduction of the sum of bond price. This means with increase in Market rate the Bond prices decreases.
Logically, when market rate and coupon was same, to get cash flow of Rs.8/- after one year we need to invest only 7.41 (Table 2) today. In above Table 3 we need to invest Rs. 7.34 today to achieve Rs. 8 in one year @9%.
Mathematically: In school, we learnt formula of Compound interest FV = PV (1+R) * N, where FV is future value, PV is present value, R is rate of interest, and N is Number of years. To find PV we can adjust formula as PV = FV / (1+R)*N. In the above formula R is inversely related to PV, if value of R is increased then the value of total ratio decreases. In above example the value of R is increased from 8% to 9% resulting in the decrease of total value of ratio from 7.41 to 7.34.
Sentimental: As B has already blocked the amount Rs. 100/- @ 8%. and market rates goes to 9% then emotionally he is negative on his investments, with the result no one will wish to buy that bond paper from B. This will Shrink the demand of bond price due to sentimental price of bond paper.
If market rates are falling then same three reasons will act in opposite way resulting in the increase of bond price.
So, we can state that bond prices are inversely proportional to the market rates, if market interest rates are rising, bond price will fall and vice versa This is called inverse relation between bond price and market interest rates.
4th part is in progress, so stay glued to be updated.
Financial Consultant Stock Analyst & Columnist
Beta Money Management Services