Final answer:
The price of a bond is dependent on the interest rate environment. If the market interest rate exceeds the bond's coupon rate, the bond's price will usually fall below par. Present value calculations adjust the future bond payments to reflect current market rates.
Step-by-step explanation:
When calculating a bond's price based on changes in interest rates, it’s important to assess how the bond’s fixed interest payments compare to the current market interest rate. If the bond’s interest rate is less than the market rate, the price of the bond will generally be less than its par value to compensate investors for the lower yields. For instance, if you expect to receive $1,080 from a bond next year and market interest rates are now at 12%, you wouldn’t pay more than $964 for it, which is the present value of the $1,080 future payment at the current 12% rate.
Similarly, when considering purchasing a local water company’s $10,000 ten-year bond with an interest rate of 6% one year before maturity, and the current market rate is 9%, you would expect to pay less than $10,000 for the bond. The actual amount you’d be willing to pay would be the present value of the expected future cash flows (final interest payment plus principal repayment) discounted at the current market rate of 9%.
As for the simple two-year bond example, when the discount rate matches the bond’s interest rate of 8%, the bond’s present value will be equal to its face value, because the interest payment and the principal repayment are both discounted at the rate they are being paid out. If the discount rate rises to 11%, the present value of the bond will be less than its face value, since the future cash flows would be discounted at a higher rate, resulting in lower present value figures.