Final answer:
A bond investor using the effective interest method calculates interest revenue on the carrying balance and market interest rate. The value of a bond will decrease if market interest rates rise. This relationship results in bonds trading at discounts or premiums based on fluctuations in market interest rates.
Step-by-step explanation:
A bond investor who applies the effective interest method calculates interest revenue based on the carrying balance of the bonds times the market interest rate.
Let's consider an example with a simple two-year bond issued for $3,000 at an interest rate of 8%. After the first year, the bond pays interest of $240 (3,000 × 8%), and at the end of the second year, it pays another $240 in interest plus the $3,000 principal. The present value of this bond, if the discount rate is 8%, would be the sum of the present values of these future cash flows. If the interest rates rise and the new discount rate is 11%, the present value would decrease because the present discounted value of future cash flows would be less.
These calculations demonstrate the inverse relationship between bond prices and market interest rates. When interest rates rise, the market value of previously issued bonds with lower coupon rates falls, and conversely, when interest rates fall, such bonds may trade at a premium.