Question

When bond prices go up, interest rates go LO36.1 a. Up. b. Down. c. Nowhere.

Short answer

The correct answer is b. Down.

Step-by-step solution

Understanding the Relationship

The relationship between bond prices and interest rates is inverse. This means that when one goes up, the other goes down.

Analyzing the Question

The question asks what happens to interest rates when bond prices go up.

Applying the Relationship

Since bond prices and interest rates have an inverse relationship, when bond prices increase, interest rates decrease.

Key concepts

Inverse Relationship

In the world of finance, an inverse relationship is a type of correlation between two variables where they move in opposite directions. A classic example is the relationship between bond prices and interest rates. Imagine a seesaw. When one side goes up, the other side tends to go down. This see-saw analogy perfectly illustrates this inverse dynamic. When bond prices increase, interest rates fall, and vice versa. This occurs because of how bonds are valued and traded. A bond is a fixed income instrument representing a loan made by an investor to a borrower. Its price is determined by the yield it offers, among other factors. If the interest rates in the broader market decrease, existing bonds with higher yields become more desirable, increasing their demand and consequently, their price.

Economic Principles

The inverse relationship between bond prices and interest rates is grounded in fundamental economic principles. Supply and demand play a significant role here. As demand for bonds increases, prices climb, which means yields (or interest rates) decrease. This is due to the fixed income nature of bonds, where the coupon payments remain constant, but the price paid for the bond changes. Here's a simplified breakdown:

• When interest rates decrease across the market, investors flock to bonds that offer higher returns from older, higher-interest-rate issues.
• This increased demand drives up the price of bonds on the secondary market.
• Since the bond's interest payment is fixed, the effective yield (interest/payment divided by the current bond price) goes down as the price goes up.

Interest Rate Fluctuations

Interest rate fluctuations are a regular occurrence in financial markets and are influenced by numerous factors, such as economic policies, inflation rates, and central bank decisions. These fluctuations impact bond prices due to their fixed-income nature. Let's take a closer look:

• Central banks may lower interest rates to stimulate economic growth. This action can make existing bonds with higher interest rates more attractive, driving their prices up.
• Conversely, if a central bank raises interest rates to curb inflation, new bonds will have better yields, making older bonds less appealing and reducing their prices.
• Inflation expectations can also lead to fluctuations. When inflation is anticipated, the interest rates on new issues rise to compensate for the decreasing purchasing power, affecting bond prices inversely.

Understanding these dynamics helps investors to make informed decisions in bond markets.