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Bond Prices and Interest Rates - Essay Example

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The price of a bond is found to exist in three states: premium, discount or par. Before we answer our specific question, we must first understand what these three states stand for. The states are the basically the price of a bond in comparison to its par value i.e…
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Bond Prices and Interest Rates

Download file to see previous pages... Similarly, a bond is said to be offered at a discount on its par value, if the bond price is less than the par value which occurs in the instance when the rate of return that is offered by the bond is less than the market rate of return that is offered on other similar risk assets in the market. A bond is said to be priced at par value if the market price of the bond is equal to the par value of the value which occurs in the instance when the rate of return offered by this bond and the required rate of return for this type of asset are equal. [1] [2]
Moving on, we will now look at the basic pricing mechanism for bonds. This mechanism is the standard procedure that is used for bond pricing and states that the value of a bond must be equal to the present value of all the future payments that the bond will make over the course of its maturity. This is directly in line with the no arbitrage rule as the cost of this asset and the generated revenues are being equalized in the pricing technique. [1] [2] A basic formula for calculating bond price is given below:
Coming to our specific question, as we can see from the mathematical equation for the derivation of bond prices, an increase in interest rates will lead to a decrease in bond prices. ...Download file to see next pagesRead More
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