Final answer:
The annual interest received from a $1,000 bond at 3.97% is $39.70. The bond decreases in value when market interest rates rise to 4.62% because new investors can get better rates elsewhere, making the existing bond less attractive. Bond prices and market interest rates have an inverse relationship.
Step-by-step explanation:
To calculate the annual dollar amount of interest that you receive from your bond investment, you need to apply the interest rate to the principal amount of the bond. The formula for calculating annual interest payments is Interest = Principal × Interest Rate. For a $1,000 bond with a 3.97% interest rate, the annual interest payment would be $1,000 × 0.0397, which equals $39.70.
If comparable bonds are now paying 4.62%, your bond will likely decrease in value. This is because new investors can get a higher interest rate from purchasing new bonds, making your bond with a lower interest rate less attractive. The decrease in value is due to the inverse relationship between bond prices and market interest rates.
For example, using given information about another scenario where market interest rates are 12%, a bond with expected payments of $1,080 (including the face value and last interest payment) would have its price set to $964 to achieve the current market yield. This demonstrates how higher market rates depress the price of existing bonds with lower rates.
When interest rates rise, previously issued bonds with lower interest rates will sell for less than face value. This happens because investors demand a discount on the older bonds to equate the yield to the current market rates. Conversely, when market interest rates fall, older bonds with higher interest rates become more valuable and can sell for more than their face value.