Economics Bonds Questions Medium
The relationship between bond prices and interest rate expectations is inverse. When interest rate expectations rise, the prices of existing bonds decrease, and when interest rate expectations fall, the prices of existing bonds increase.
This inverse relationship can be explained by the concept of opportunity cost. When interest rates rise, new bonds are issued with higher coupon rates, making existing bonds with lower coupon rates less attractive to investors. As a result, the demand for existing bonds decreases, causing their prices to fall.
Conversely, when interest rates fall, new bonds are issued with lower coupon rates, making existing bonds with higher coupon rates more desirable. This increased demand for existing bonds leads to higher prices.
Additionally, the inverse relationship between bond prices and interest rate expectations can be understood through the concept of present value. As interest rates rise, the discount rate used to calculate the present value of future bond cash flows increases. This higher discount rate reduces the present value of future bond payments, resulting in lower bond prices.
On the other hand, when interest rates fall, the discount rate used to calculate the present value of future bond cash flows decreases. This lower discount rate increases the present value of future bond payments, leading to higher bond prices.
Overall, the relationship between bond prices and interest rate expectations is inverse due to the impact of changing interest rates on the attractiveness of existing bonds and the present value of future bond cash flows.