Discuss the relation ship between bond prices and interest rate fluctuation?
The relationship between bond prices and interest rate fluctuation can be described as an inverse relationship. When interest rates rise, bond prices typically fall, and when interest rates decline, bond prices generally rise.
This inverse relationship can be explained by the concept of yield. The yield of a bond represents the return an investor will receive by holding the bond until maturity. As interest rates rise, newly issued bonds offer higher yields to attract investors. Consequently, the existing bonds with lower yields become less attractive, resulting in a decrease in demand. To entice investors to purchase these existing bonds with lower yields, their prices must decrease.
Conversely, when interest rates decrease, newly issued bonds offer lower yields. This makes existing bonds with higher yields more attractive, leading to increased demand for these bonds. Consequently, the prices of existing bonds rise to match the yield potential offered by newly issued bonds.
The duration of a bond also influences the sensitivity of its price to interest rate fluctuations. Bonds with longer durations generally experience greater price changes in response to interest rate movements compared to bonds with shorter durations. This is because the future cash flows of longer-term bonds are discounted at a higher rate due to the longer time period involved, making them more sensitive to changes in interest rates.
Overall, the relationship between bond prices and interest rate fluctuation is important for investors to consider when making investment decisions in fixed-income securities.