Why bond prices move inversely to changes in interest rate. Created by Sal Khan.
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Finance and capital markets on Khan Academy: Both corporations and governments can borrow money by selling bonds. This tutorial explains how this works and how bond prices relate to interest rates. In general, understanding this not only helps you with your own investing, but gives you a lens on the entire global economy.
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I think he meant that in terms of zero interest bonds only. If you have a market with let's say a zero interest rate Bond and a 10% interest rate Bond, you would want to buy the 10% Bond of course since you would make money from the interest on top of principle. But if you can get the zero interest rate bond at a low enough price that it equates to a 10% payout you would be willing to buy the zero interest rate bond. For example if you can get a zero interest rate bond with a payout of $1000 at the end of two years, if you pay about $909 you should get a ten percent return.
나도 미국에서 수년가 칸아카데미 이용했던 사람으로서 이 칸 선생님응 진짜 존경한다. 미국은 달라... 이분은 공짜 무료 로 이런거 갈키는데 거의 창시자임... 미국이어서 가능 한국에서는 절대 불가능... 대학교육만 봐도 미국대학 근처에 한국처럼 술집 번화가 자체가 생겨날수 없음 그냥 닥치고 아닥하고 공부 ... 기본적으로 전문대 강사라도 해도 미국에서의 교육에대한 자부심이 쩔고 .. 내대학의 경우도 통계교수가 얘기했던게 우리가 미국에서 티칭 스킬이 10위권이다 올해는 14위로 내려갔다 이러면서 점수를 안주려고 하지만 학점에 관계없이 어려워도 이런 교수들 만나 의미있는 교육 받고 공부했다는거에 자부심이 든다. 이 칸 선생님때문에 인도사람들이 더욱 친근해지고 조아졌었징 똑똑합니다 진짜 수학 25구구단이었던가 25진법인가 까지 외우는 나라. 한국은 진짜 달라져야돼 자기 밥그릇만 챙기면 더이상 미래가 없음. 공무원 마니 뽑지 말고 중소기업 마니 뽑아요
What a brilliant way of explaining the present value of a bond using discounted cash flows, without even introducing it as an NPV of a bond. This inductive reasoning is brilliant.
PV of Zero Coupon Bonds= Bond's Price/(1+R) where R= Coupon Payments
PV of Normal Bond= Bond's Coupon payments/ (1+R)^t +Bond's Principal/ (1+R)^t
t= number of years
Every time the interest rate, or discount rates, increase, the price of a bond, or its present value decreases.
We also have to distinguish between:
Current Yield= Annual Coupon Payments/Current Market Price of a Bond
Yield to Maturity= [Cash-Flows + (F+P/Number of years to Maturity) / (F+P/2)
where F: Face Value of a bond
P= Market Price of a bond
When the credit issuers are solvent and there's no or every small change of default, then there bonds' yields are lower while their prices are higher. This is because they will most likely pay their debt obligations.
That's the reasons economically-weak countries like Greece, Spain, Portugal and Argentina offer very high yields on their bonds.
Wow! Amazing!! I'm almost done studying for financial mathematics for actuaries and not once did the #1 recommended study manual (asm manual) mention what's really the difference between a given yield rate and the rate of the coupon payments.
I thought the 10% interest is only on the initial principal invested (ie $1000) and does not compound! This math only makes sense if the interest compounds!!!! ....and I don't think it usually does with bonds (but I'm no expert)
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When the fed rise rates, treasury bonds also rise. Since they are less risky the company needs to rise his own rates to remain attractive. If both (treasury and company ) pays the same. Nobody is going to take extra risk for same return.
So the price I am willing to pay will continue to decline inversely related to the increasing interest rate percentage quoted on the bond.
If an investor is selling me a bond with x amount interest rate, but new bond interest rates increased in value after the investor purchased the underlying bond
Then, it is in my best interest to buy the underlying bound at a discounted price paralleling the value of the higher interest rates, so that I can benefit in transferring that 15 percent value in the form of a discount, saving me money when I buy the bond.
it depends to whom and how you're loaning the money... but interest rates are typically set by your country's central bank (in my case, the bank of canada sets the rate). in this example, let's assume (in a very general way), that you are loaning money to company A thru an investment firm, you will receive "interest" from company A based on the "bank rate".
Okay i need a little help .. ( the video at 8:30 mins) i don't understand why he is adding the 1.10 .. i get the .10 as this is the interest rate but the part i don't understand is where is the 1 coming from ?? thanks a bunch
If its 10% interest of a $1000 bond, why is it compounded? It's not as if the interest from the first year is going to be added to the value of the bond, can someone explain to me? Would really appreciate it.
10% interest is the market rate of interest you could have earned if you invested that $1000 somewhere else, say an interest paying bond. So you could have earned 1000(1.1)^2 = $1210. You want to see how much that $1000 is worth to you, given the interest rate and the fact you could have invested your money elsewhere at that interest rate. So you do the reverse process which is $1000/(1.1)^2 = $826.
Shambhu Neupane: Yes, anything which is not too out of my control I am happy with my knowing this is not a chance game like the stock market, or worse, an individual stock. When you touch it, especially a rising market, there is no guarantee that it will do what you desire. Bonds are not a "greedy" vehicle. These are a nexus to the sound rewards it provides.
For example, if it is quoted as 10% semiannual coupon. The 10% is annual-basis, but your treatment has to factor in the semi-annual basis. Basically, you always have to divide the rate to the appropriate periodicity given.
Quick question. So if the interest rates go down and the demand for bonds increase, do the prices of bonds increase? And if they do, doesn't the increase in these prices discourage buyers to go back to the interest rates savings?
Thank you for the explanation, I had a hard time trying to understand this relation !
I just have a question on your calculus when you talk about a zero coupon : if the interest become ten percent, and reasoning by the logic you show at the beginning : The first year I get 10% of 1000 that 100, the second year I also get 10% of 1000 that 100 + the 1000 of the bond.
Finally I got : 1000+100+100=1200=1000 + 1000*i + 1000*i = 1000 (1 + 2*i) and not 1000*((1+i)^2) : because the money of the first interest is not reinvest or is it and that would explain why we have 1000*((1+i)^2).
Looking Forward to your response ! Thanks
Yep...I was thinking the exact same thing. He seemed to be treating it as compound interest even though his initial explanation suggested he was referring to simple interest. However, I would use compound interest to do my calculations in practice (at least here in Nigeria) cos most banks allow you to do a rollover of interest onto your capital if you do a fixed deposit investment. That way it allows me to have a more accurate picture as to how much I should really price the bond; otherwise, I just put my money in fixed deposit and let the principal compound based on the interest rate.
coupon rate and interest rate are different things right ? and interest rate u mean as in the interest u get when u save money in a bank ? or is there another interest rate for bonds specifically ? dumb questions but pls someone answer
+LORD SAIYAN The interest rate is just the discount rate, lets say in your case if you were able to invest somewhere else and surely get 8% returns you would use 8% as interest rate for your calculation. Or you can think of it this way too, if you were to buy another bond of a similar type you would make 8% returns, if a bond has a coupon rate less than 8% you want to buy it at a discounted price so you can make up the earnings through the gains when you get the final face value payment.
Maybe you can help with another bond trading question...I'm trying to understand how bond mutual funds decrease in value. If a bond will pay interest on principal, and interest rates have increased since the bond was issued, why would a portfolio manager liquidate it at it's discounted price to par and realize a loss when it could just be held to maturity and redeemed at par? If it were advantageous to liquidate the lower coupon bond and reinvest at higher rates, then why aren't bond mutual funds reflecting this with a higher net asset value? Or does the NAV lag the change in interest rates? It's just difficult to understand how a bond fund is losing money unless they are either selling at a discount or being dinged by defaults from bad credit investments.
+LORD SAIYAN Coupon rate for bonds- Coupon rate for a 100 $ is 5%, you get interest of 5$ each year. Does not matter if interest rate goes up or down. Interest rate is fixed by the rate federal banks lend to other banks, and it can fluctuate, not every day but once a year perhaps. Loan and savings rate is determined by this base rate. Another measure is LIBOR which is a rate which is determined by major banks and will determine savings and lending rates. So coupon (is set by company which issues bonds) and interest rate (decided by federal banks i.e government) are quite different.
+Twixters Official I think the concept remains the same- you will have to buy the bond at premium but price may be adjust based on only one coupon pending for last 6 months, because seller already got previous 3 coupons, Or when you delay more such that less than 6 months remaining , you may have to pay accrued interest to the seller for the time he holds the bond.
I have a doubt.. So is that mean in zero coupon bond interest is not paid in between years its directly been paid on maturity date(interest + par value)?...and while buying the bond how the rate of bond is fixed its the same way showed in above video? and other thing is instead of buying bond we can keep put this money in fixed deposit where we can get more interest rate and i can take that money whenever i wanted.....?
reply will be appreciated
+Eric Johnson I am really not a pro at bonds just learning things but just my thoughts –
There are lot of factors that may be considered while investing in bonds, be it a retail investor or a fund manager. Interest rate rise generally is good for the issuer, while investor is at loss holding the bond till the term. Again investor can be active investor like Institutional firm, money managers that may consider liquidating it below par to acquire new position with higher interest rate. So yes liquidating is better option. For retail investors they could consider put options, convertible bonds, or choose reinvestment options too if they want better liquidity as there might not be opposite side orders when prices fall and calculated risk limiting their losses with falling prices. But then there might be many reasons for liquidity too based on investors goals, maybe buyers are just market makers or Algo traders, don’t want to keep positions for long. I think you’re right there too. And for the last part yes, while investing obviously creditworthiness of the issuer is a thing to consider, best way to loose money is to invest in junk bonds, but again that’s part of the game. Someone’s loss is others gain. Ultimate goal is same for all- maintain a higher yield position.
Coming back to zero coupon bond they are famous because for longer term you could buy them at considerably low prices, may be good for pension funds or mf companies, buy side players.
Maybe you can answer this question:
Why do bond mutual funds lose money? I understand that when interest rates rise, older issues with lower coupons trading on the secondary market will be discounted to par, but why would someone liquidate the bond and realize a capital loss when they could just hold the bond to maturity and redeem it a par? I haven't done the math, but at least one reason I could assume would be that liquidating the bond at a discount may be preferable when the capital is going to be reinvested in another higher yielding security. In the case of a bond fund, that would be another bond, would it not? So if there were some advantage to liquidating a bond at a discount to par, wouldn't that mean that it would be done in order to generate higher returns for the fund? Otherwise, hold the bond until maturity and don't take a capital loss. Then the only way you could lose money is by credit default, correct?
+Subash Konar yes, as the name suggests there is no coupon associated with zero-coupon bonds or discount bond, you will have to serve the term for return depending on what options do you have, you can sell or put option. Pricing is similar price depending upon how longer your term is and may fluctuate and riskier in volatile market effecting your overall yield. I don't know which country do you want invest in fixed deposit kind of thing but CDs are good alternative although you may not have much liquidity, unless you are buying through brokers.
sorry, something I just don't get quite grapple with - why when interest rates go up to say from 10% to 15% for a bond, wouldn't the issuer want to pay more so that he'll receive more money from the interest rate in the end (or when the bond matures)? I'm still a little new to this so forgive me
yeah, but unfortunately companies thriving doesn't always mean middle class and poor people are thriving, which is kind of what we see today in our economy, hence the term some refer to our economic recovery as a "bubble". In the early 1980's we had inflation (alot of money in the economy that wasn't evenly spread) so what the fed did under Paul Volker was raise interest rates to take the amount of money out of the system and basically collapsed the economy and reset it. Prices went down to accommodate for less money in the system and we saw economic prosperity. interesting stuff :)
+fleshcookie The Federal Reserve regulates interest rates. for example, now they are very low. VERY low. Central banking (the federal reserve, the guys who print money) have an interest rate of 0%, and this finances companies from having their prices go down because supply is lower due to the recession. They are not raising them NOW because the reason prices are so high are precisely because of THEM. If interest rates were to rise, the economy would not be able to sustain it because there is a lack of supply in a true consumer to finance/keep such bloated companies up to par with their high prices
can someone quickly explain, at the very end of the video, why would you want to pay a lower amount for a higher expected return? surely a higher expected return is a good thing? thus you'd pay more for the privilege?
Thanks in advance!
I think you're getting mixed up with what that 1.15% represents.
In the open market, you could buy a Bond that pays 15%. That Zero Coupon, which is essentially trying to be sold to you, is only offering 10%. So you'd pay less for the lesser return.
Can you explain why a bond mutual fund loses money? I understand that when interest rates rise old bond issues with a lower coupon trade at a discount to par. What I don't understand is this: if I were to consider liquidating a bond, and I knew it would trade at a discount, I would only do so knowing the capital loss would be offset by trading into a higher yielding security and the net benefit would be to generate a higher return. If I were going to liquidate a bond at a discount and take a capital loss with nothing to offset the loss, why not just hold on the bond until maturity and redeem it for par?
+Failed Trolls Thank you for your response. Maybe I am mistaken, but I thought we are talking about any kind of bond here, like bonds issued by a bank as well as bonds issued by say Coca Cola of McDonald's. But I would assume that each company has a different level of risk and hence different interest rates on its bonds. So I understand how the interest rate of the central bank lending money to banks works, but how does that affect the interest rate for the bonds of any other company in the market?
Thanks can you do a slightly more advanced one in context of the current situation. 10yr is trading at a premium (assume that also include the risk premium) and generally went up on the recent $10bn taper announcement. Since taper would raise rates, prices would fall, but then the fed promise low rates as well.. all quite confusing.
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