Bonds, Interest Rates and the Impact of Inflation - Business in Greater Gainesville
Jan 3, Inflation and interest rates are often linked, and frequently referenced in In the United States, the interest rate, or the amount charged by lender to a banking, interest rates and inflation tend to be inversely correlated. If you're considering investing in bonds, either directly or through a mutual but there's an important rule to remember about the relationship between the A rise in either interest rates or the inflation rate will tend to cause bond prices to drop. Dec 15, At first glance, the inverse relationship between interest rates and For a person to pay $ for this bond, he or she must be happy These examples also show how a bond's coupon rate is directly affected by national interest rates, and consequently, Understanding Interest Rates, Inflation And Bonds.
This bond isn't giving more, so the price will go down. Likewise, if interest rates go down, this bond is getting more than what people's expectations are, so people are willing to pay more for that bond. Now let's actually do it with an actual, let's actually do the math to figure out the actual price that someone, a rational person would be willing to pay for a bond given what happens to interest rates. And to do this, I'm going to do what's called a zero-coupon bond.
I'm going to show you zero-coupon bond. Actually, the math is much simpler on this because you don't have to do it for all of the different coupons. You just have to look at the final payment.
There is no coupon. So if I were to draw a payout diagram, it would just look like this. This is one year. This is two years. Now let's say on day one, interest rates for a company like company A, this is company A's bonds, so this is starting off, so day one, day one. The way to think about it is let's P in this I'm going to do a little bit of math now, but hopefully it won't be too bad. Let's say P is the price that someone is willing to pay for a bond.
Let me just be very clear here. If you do the math here, you get P times 1. So what is this number right here? Let's get a calculator out. Let's get the calculator out.
If we have 1, divided by 1. Now, what happens if the interest rate goes up, let's say, the very next day? And I'm not going to be very specific. I'm going to assume it's always two years out.
The Relationship Between Bonds and Interest Rates- Wells Fargo Funds
It's one day less, but that's not going to change the math dramatically. Let's say it's the very next second that interest rates were to go up. Let's say second one, so it doesn't affect our math in any dramatic way.
Let's say interest rates go up. So now all of a sudden, so interest, people expect more.
- Relationship between bond prices and interest rates
- Bonds, Interest Rates and the Impact of Inflation
- What’s the Relationship Between Inflation and Interest Rates?
We'll use the same formula. We bring out the calculator. We bring out the calculator, and I think you have a sense we have a larger number now in the denominator, so the price is going to go down. Let's actually calculate the math. So now, the price has gone down. Now, just to finish up the argument, what happens if interest rates go down? What is someone willing to pay for this zero-coupon bond? The price is, if you compound it two years by 1. Though the ups and downs of the bond market are not usually as dramatic as the movements of the stock market, they can still have a significant impact on your overall return.
They move in opposite directions, much like a seesaw. The opposite is true as well: When bond prices rise, yields in general fall, and vice versa.
What moves the seesaw? However, other factors have an impact on all bonds. A rise in either interest rates or the inflation rate will tend to cause bond prices to drop. Inflation and interest rates behave similarly to bond yields, moving in the opposite direction from bond prices. If inflation means higher prices, why do bond prices drop?
The answer has to do with the relative value of the interest that a specific bond pays. Rising prices over time reduce the purchasing power of each interest payment a bond makes. Why watch the Fed?
Relationship between bond prices and interest rates (video) | Khan Academy
Inflation also affects interest rates. The Fed takes an active role in trying to prevent inflation from spiraling out of control.
When the Fed gets concerned that the rate of inflation is rising, it may decide to raise interest rates. To try to slow the economy by making it more expensive to borrow money. For example, when interest rates on mortgages go up, fewer people can afford to buy homes.
The Relationship Between Bonds and Interest Rates
That tends to dampen the housing market, which in turn can affect the economy. When the Fed raises its target interest rate, other interest rates and bond yields typically rise as well.
New bonds paying higher interest rates mean existing bonds with lower rates are less valuable. Prices of existing bonds fall. An overheated economy can lead to inflation, and investors begin to worry that the Fed may have to raise interest rates, which would hurt bond prices even though yields are higher.