Final answer:
The value of a bond is affected by its carrying value, interest payments, principle amount, and market interest rates. To calculate the present value of a bond, future cash flows are discounted back at the current market discount rate. When market rates rise above the bond's rate, its price decreases to provide a competitive yield.
Step-by-step explanation:
When determining the value of a bond, the crucial factors to consider are the bond’s carrying value and the effective interest rate. The bond's price is influenced by its interest payments and the principle, as well as the current market interest rates which serve as the discount rate for calculating the present value (PV) of future cash flows.
Example Calculation
Let’s look at a simple two-year bond with a face value of $3,000 and an annual interest rate of 8%. The interest payments are $240 per year. When the discount rate matches the bond's interest rate (8%), its current value will be equivalent to the sum of its future cash flows. If interest rates rise and the discount rate becomes 11%, the bond’s price must be recalculated by discounting its future cash flows at this new rate, reducing its present value.
To illustrate, the first year's interest is $240, and at the end of the second year, an additional $240 in interest is paid along with the $3,000 principle. Calculating the present value of these payments at an 8% discount rate will maintain the bond's face value. However, if recalculating at an 11% discount rate, the present value of the bond decreases, as the future cash flows are discounted at a higher rate.
Consideration of Risk
Bonds with no risk are assumed to sell at face value, but if market interest rates rise above the bond’s rate, its price will drop below face value to offer a yield competitive with the new market rates. For instance, if market rates rise to 12%, the seller needs to lower the bond’s price to make its annual return of $80 and final repayment of $1,000 appealing to investors who can otherwise obtain 12% elsewhere.