Final answer:
Bond prices and interest rates are inversely related and determined together in the money and loanable funds markets. As interest rates fall, the bond's fixed payouts become more attractive, increasing its price; the opposite happens when interest rates rise. Essentially, when rates change, bond prices adjust to maintain a competitive rate of return.
Step-by-step explanation:
The relationship between bond prices and interest rates is a fundamental concept in finance. To answer the student's question, bond prices and interest rates are inversely related and are determined together in the money and loanable funds markets. When interest rates rise, the price of existing bonds falls to yield a competitive rate of return in comparison to new bonds issued at the higher rates. Conversely, when interest rates fall, existing bonds with higher rates become more valuable, leading to an increase in their price.
Bonds are essentially loans wherein the bond issuer borrows from the bondholder and is obliged to pay back the debt with interest, known as the coupon. If a bond is issued at a 5% interest rate and the market rates drop to 3.5%, this bond's higher payout becomes more attractive, driving up its price. If market rates increase to 6.5%, the bond's value declines since investors can find better rates elsewhere.
Issuing bonds and taking bank loans are both methods for firms to raise capital. However, they differ in whom you are persuading to lend money. Bonds typically involve convincing numerous bondholders rather than a single bank, which can be advantageous or disadvantageous depending on the firm's relationship with potential lenders and the transparency of information.