What’s the relationship between bond prices & the market interest rate? What’s the logic behind this relationship?
In: Economics
Bonds are a commitment for a party to pay a set amount in the future. The value of that future payment today is dependent on the current interest rate.
For example, if somebody promises to pay me $105 one year from now and the prevailing interest rate is 5% then it is worth it for me to buy the right to receive that payment for $100 (I’m ignoring any risk premium for simplicity).
Based on standard net present value calculations the higher the interest rate the lower the current price of the future payment and vice versa. Prices and interest rates are inversely related.
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