IMPACT OF INTEREST RATE CHANGES ON SECURITY VALUES
The variability of financial security prices depends on interest rates and the characteristics of the security. Specifically, the factors that affect financial security prices include interest rate changes, the time remaining to maturity, and the coupon rate. We evaluate next the impact of each of these factors as they affect bond prices. The impact on equity prices is similar. Table 3–4 summarizes the major relationships we will be discussing
Refer back to Example 3–4. Notice in this example that the present values of the cash flows on bonds decreased as interest rates increased. Specifically, when the required rate of return increased from 8 percent to 10 percent, the fair present value of the bond fell from $1,152.47 to $1,000, or by 13.23 percent (i.e., (1,000 1,152.47)/1,152.47 .1323 13.23%). Similarly, when the required rate of return increased from 10 percent to 12 percent, the fair present value of the bond fell from $1,000 to $874.50, or by 12.55 percent ((874.50 1,000)/1,000).
Refer back to Example 3–4. Notice in this example that the present values of the cash flows on bonds decreased as interest rates increased. Specifically, when the required rate of return increased from 8 percent to 10 percent, the fair present value of the bond fell from $1,152.47 to $1,000, or by 13.23 percent (i.e., (1,000 1,152.47)/1,152.47 .1323 13.23%). Similarly, when the required rate of return increased from 10 percent to 12 percent, the fair present value of the bond fell from $1,000 to $874.50, or by 12.55 percent ((874.50 1,000)/1,000).
While the examples refer to the relation between fair values and required rates of return, the inverse relation also exists between current market prices and expected rates of return—as yields on bonds increase, the current market prices of bonds decrease. We illustrate this inverse relation between interest rates on bonds and the present value of bonds in Figure 3–1
Notice too from the earlier example that the inverse relationship between bond prices and interest rates is not linear. Rather, the percentage change in the present value of a bond to a given change in interest rates is smaller when interest rates are higher. When the required rate of return on the bond increased from 8 percent to 10 percent (a 2 percent increase), the fair present value on the bond decreased by 13.23 percent. However, another 2 percent increase in the required rate of return (from 10 percent to 12 percent) resulted in a fair present value decrease of only 12.55 percent. The same nonlinear relationship exists for current market prices and yields to maturity. Thus, as interest rates increase, present values of bonds (and bond prices) decrease at a decreasing rate. This is illustrated in Figure 3–1 .
The relationship between interest rates and security values is important for all types of investors. Financial institutions (FIs) such as commercial banks, thrifts, and insurance companies are affected because the vast majority of the assets and liabilities held by these firms are financial securities (e.g., loans, deposits, investment securities). When required rates of return rise (fall) on these securities, the fair present values of the FI’s asset and liability portfolios decrease (increase) by possibly different amounts, which in turn affects the fair present value of the FI’s equity (the difference between the fair present value of an FI’s assets and liabilities).
The relationship between interest rates and security values is important for all types of investors. Financial institutions (FIs) such as commercial banks, thrifts, and insurance companies are affected because the vast majority of the assets and liabilities held by these firms are financial securities (e.g., loans, deposits, investment securities). When required rates of return rise (fall) on these securities, the fair present values of the FI’s asset and liability portfolios decrease (increase) by possibly different amounts, which in turn affects the fair present value of the FI’s equity (the difference between the fair present value of an FI’s assets and liabilities).
No comments:
Post a Comment