2014-19 Interest rates and bond prices

Interest rates are at record lows and will, eventually, increase. This means bond prices will fall

IMPORTANT: we will be studying the relationship between interest rates and bond prices later on in the course. Since a lot of students are unclear about the relationship, it is a good to think about it ahead of time.

1. What is a bond? It is a promise to pay predetermined amounts of money in the future. 
2. What determines the price of a bond? The amount you need to generate future payments identical to the payments the bond will provide.
3. How to avoid a mistake? Bu remembering that, once the bond is sold for the first time, the price at which it is sold is irrelevant.

I will provide a simple example, of a consol. A consol is a bond that has no maturity day. It pays the interest forever. It is easier to analyze a consol since you do not need to consider a maturity date.
In the example, the consol has a face value of $100, pays 5% per year, and sells for $100.

The points below correspond to the points above

1. The consol will pay the owner $5 per year forever.
2. How much do you need to earn $5 per year? 

- if the interest rate is 5%, you need $100. You deposit $100 in the bank and get 5% of $100, or $5 per year

- if the interest rate is 2.5%, you need $200. You deposit $100 in the bank and get 2.5% of $200, or $5 per year

- if the interest rate is 10%, you need   $50. You deposit $50 in the bank and get 10% of $50, or $5 per year.

So if the interest rate is 2.5% the price of the consol is $200, if the interest rate is 5% the face value of the consol is $100 and when the interest rate is 6.2% the price of a consol is - well, you can calculate it yourself

     3. To calculate the price of the consol, we took two things into account: the yearly payment, and the interest rate. The price at which the consol sold, nor the face value, entered into the calculation. As often happens, the consol could sell for $99 (at a discount) or for $101 (at a premium) - without affecting the price of the consol later on. Similarly, a consol with a face value of, for example, $120 which happens to pay $5 per year would have the same price as a consol with the face value of $100 which pays$5 per year.