Final answer:
The market price of bonds falls when interest rates rise. This is because existing bonds with lower interest payments become less appealing compared to new bonds at higher rates, so their prices must be reduced in order to compete. A rise in rates leads to a decrease in the present value and thus the market price of a bond.
Step-by-step explanation:
If interest rates rise, the market price of bonds typically falls. This is because the fixed interest payments of the bond become less attractive when compared to new bonds that could be issued at higher current interest rates. Hence, to sell the older bond, the price must drop to offer a similar yield to those new higher-interest bonds.
For example, consider a bond with no default risk that was sold at face value at $1,000 with an interest rate of 8% (or $80 per year). If market interest rates increase to 12%, the owner of the bond will suffer an unexpected loss if they decide to sell, because they'll need to lower the bond's price to make it competitive with new bonds issued at the 12% rate.
The present value calculation is used to assess how the changing interest rates affect the price of existing bonds. With an increase in interest rates, the present value of the bond's payments decreases, leading to a decrease in the bond's market price.