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Q: Identify and explain what factors may cause a change in the market/fair value of fixed rate notes and bonds?
A: Investors expect a fair rate of return from bonds, based on prevailing interest rates, term length of the bonds, and their credit rating. [ Since prevailing interest rates change continually, there is interest rate risk in holding bolds if the investor wants to sell the bonds before their maturity. For instance, if a bond, with a $1,000 par value, is issued with a nominal interest rate of 5%
when bonds with similar risk and terms are also at 5%, then the bond can be sold for $1,000. But if interest rates rise to 6%, then the price of the bond is going to drop so that the bond’s $50 interest payment per year will have a yield to maturity (YTM) of 6%. So there are capital gains and losses associated with bonds if they are sold before maturity, so even with securities that are considered risk-free in terms of default, such as U.S. Treasuries, there is still interest rate risk. Another way to look at bond prices and yields is to note that the price of a bond is equal to the sum of the present values of the coupon payments and the principal. When interest rates change, then the present value of those payments changes, also, causing the price of the bond to change with it. Note that since the interest rate factor is in the denominator, it is inversely related to the bond price. The relationship between bond prices and prevailing interest rates is neither simple nor linear. How much bond prices rise or fall depends on the terms of the bonds, the current bond yield, and whether the bonds have embedded options, such as being callable or putable. Burton G. Malkiel has described most of the important general relationships between interest rates and bond prices. for more visit ]
Expert answered|danimai|Points 451|
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Asked 12/18/2011 8:27:34 AM
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