Factors influencing Price of a Bond

Effect of Discount Rate on Price of a Bond:

It is obvious from the above formula that the discounting rate or market interest rate plays main role in pricing a bond. Higher the discounting rate or the expected rate of return, lower will be the price of a bond. In other words, if we purchase a bond at lower levels compared to other bonds with the similar profile in the market, you will get more rate of return on your investment. The conclusion is ‘interest rates and bond prices move in opposite directions’. The following statements hold good at the beginning of the bond period.

• A bond will sell at par value if the discounting rate is equal to the coupon rate. Note that discounting rate is the interest rate that could be earned by investing in alternative avenues in the market and the coupon rate is the interest rate offer by the bond.
• A bond will sell at above par if the discounting rate is lower than the coupon rate.
• A bond will sell at below par if the discounting rate is more than the coupon rate.

Interest gets accumulated as the time passes by till the time of coupon payment. Because of this accrued interest the price of a bond may be more than the par value even if the market interest rate is more than the coupon rate. The settlement price of a bond is the present value of future cash flows of the bond less accrued interest. The prices quoted in the market are without accumulated interest. This quoted price is called clean price. The settlement price or dirty price is the sum of clean price and the accumulated interest.

Effect of Maturity on Bond Pricing:
Long term bonds are offered at lower prices compared to short term bonds.This is because the longer a bond’s term to maturity, the greater the risk that there could be future increases in inflation. As the inflation increase the market interest rate increases. So the larger the current discount rate that is required the lower the bond’s price.

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Sathish Emmadi

Sathish Emmadi is a co-founder & editor at Lastbull.com. He is presently working in IT for one of the world’s top mutual fund companies. Handled multiple projects in BFSI (Banking,Financial Services and Insurance) domain. An Engineering Graduate from NITW.

Related posts:

1. Clean Price and Dirty Price of a Bond
2. Bond Market Terminology
3. Accrued Interest of a Bond
4. Classification of bonds
5. Bond Market/Fixed Income Market Basics