A higher interest rate (discount rate) would?
A. reduce the price of corporate bonds
B. reduce the price of preferred stock
C. reduce the price of common stock
D. all of the above
I remember reading about the relationship between interest and bonds/stocks.
When the FR raises rates the price of bonds goes down.
When the rates go up stocks go up because the risk free rate increased, so stocks must cover the risk free rate + the premium rate.
I like A for the best answer....Is that correct???
I think all of the above because:
A. when rates go up you can buy a bond for less and get the same interest payments.
B. For the same reason, I would pay less for preferred stock paying the same interest payments as before rates went up.
C. If interest rates are high, why not buy a bond instead of a stock, E=especially if buying stock with borrowed money (on margin)?
No, option A is not correct. A higher interest rate (discount rate) would actually reduce the price of corporate bonds, as stated in your explanation. However, options B and C, which state that a higher interest rate would reduce the price of preferred stock and common stock, respectively, are incorrect. In general, higher interest rates can negatively impact the price of bonds, as their fixed interest payments become less attractive compared to other investments. However, the impact of interest rates on the price of stocks, whether preferred or common, is more complex and can be influenced by various factors, such as market conditions, company performance, and investor sentiment.
Actually, the correct answer is option D - all of the above. An increase in interest rates, also known as the discount rate, affects both bonds and stocks.
Firstly, when interest rates rise, the price of corporate bonds decreases because their fixed interest payments become less attractive compared to the higher interest rates available in the market. Investors demand a higher yield from bonds to compensate for the higher opportunity cost of tying up their money in fixed-income securities when interest rates are higher.
Secondly, an increase in interest rates reduces the price of preferred stocks. Preferred stocks are essentially hybrid investments that have characteristics of both bonds and common stocks. They pay a fixed dividend, like bond interest, and are more sensitive to changes in interest rates. When interest rates rise, the fixed dividend on preferred stocks becomes comparatively less attractive, causing their prices to decrease.
Lastly, an increase in interest rates also influences the price of common stocks. When interest rates rise, it implies that the risk-free rate of return (such as government bond yields) has increased. As a result, investors may demand a higher rate of return from their investments, including common stocks. This increased required rate of return may lead to a decrease in the price of common stocks, as investors expect greater returns to compensate for the higher risk-free rate.
To sum up, a higher interest rate (discount rate) tends to reduce the prices of corporate bonds, preferred stocks, and common stocks, making option D the correct answer.