We often think that when interest rates go up, bond prices go up.
However, experts explain that if interest rates rise, bond prices fall.
Why is that?
This is because those who call themselves experts memorized the contents of the book without thinking about why such a phenomenon occurred.
Today, we will see why bond prices fall when interest rates rise.
First, a bond is the right to lend money to someone and get it back.
For example, a bond is a legitimate qualification for A to lend B $100 and get it back later.
I know this, but when interest rates go up that affect the interest on the money you're going to get back
Why do bond prices fall?
We think so because we only considered two people, A and B.
Financial markets around the world are not only A and B, but also third party C.
A, who lent the money, can get the money back from B, but the date on which B decided to return the money has not yet arrived.
A, who needed money, tells C.
A: C I'm going to get $100 from B at 110 dollars with interest a month later, but I'll sell you that right for 90 dollars
C: Oh, then I can make another 20 dollars if I wait a month? Good!
This is how the transaction between A and C is concluded.
This difference of $20 is called the discount rate.
Self-proclaimed experts say. The discount rate and the interest rate are the same.
People who don't know economics ask.
"Why is the discount rate and the interest rate the same?"
"That's how it is. It's complicated to be specific, so just understand that."
I doubt that those who call themselves experts will be able to solve that question in a complicated way.
As you can see in the case above, A lent B money to make $10 (10% interest rate)
As A and C do the transaction, C can earn $20 (because they invested $90 to make $110).
C's expected return rose to $20 and the right to get money back (bonds) traded at $90.
In the end, as the rate of return rose, the price of the right to get money back (bond) fell.
Does the logical structure make sense?
We only looked at the stories of A, B, and C, but there are more people in the world.
So we're expressing that when interest rates go up, bond prices go down.
In fact, this metaphor may not be appropriate, but I don't think it's too much for those who don't know economics to understand.
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