Final answer:
When market interest rates rise, the market prices of existing fixed-rate bonds fall because new bonds issued at higher rates make older bonds less attractive. The present value of future cash flows from the older bonds becomes less when compared to new offerings, causing their market price to drop. This is a fundamental concept related to the interest rate risk in bond investing.
Step-by-step explanation:
When market interest rates rise, the market prices of existing fixed-rate bonds typically fall. The reason for this is grounded in the laws of supply and demand that prevail in the financial markets. Fixed-rate bonds pay a set amount of interest over time. If a bond is issued at a 3% interest rate, it will pay that rate until it matures. However, if market interest rates increase to 4%, new bonds are issued that pay this higher rate, making the older bonds less attractive since they have a lower return.
Investors looking for the best return on their investment would prefer the new bonds paying 4% over the existing bonds paying only 3%. Consequently, to sell the older bond in this market, the price must decrease to offer a similar yield to the new bonds with higher rates. This relationship between interest rates and bond prices is an essential concept in financial markets known as the interest rate risk of bond investing.
The present value calculation helps illustrate why this happens. Present value is the current worth of a future sum of money or stream of cash flows given a specified rate of return. When interest rates rise, the present value of a bond’s future cash flows, which are fixed, becomes less valuable, causing the bond's price to drop. It's important to note that while rising interest rates decrease bond prices, the actual coupon payments from the bond do not change. The fluctuation concerns the bond’s price on the market, not the interest it pays out.
Supply and demand dynamics show that higher interest rates will decrease the quantity demanded for old bonds, as they offer lower returns compared to new bonds issued at the higher current rates. Conversely, when interest rates drop, the existing bonds with higher rates become more attractive, increasing their market price. Understanding this inverse relationship between interest rates and bond prices is critical for investors, as it affects their portfolio's value and potential investment strategies.