Bond Pricing Theorems
Bond Pricing Theorems. Being fixed income securities bonds are issued with a fixed rate of interest known as coupon rate. The calculation of coupon rate is based on the face value and maturity of the bond.
At the time of issuance, the coupon rate seems to be equal to the prevailing market interest rate. Based on the market condition, interest rate may change. If the current market interest rate is higher than the coupon rate of a bond, the bond generates a lower return and becomes less attractive to the investors. Therefore, the price of the bond declines below its face value.
On the other hand, if the market interest rate declines below the coupon rate, bond price will increase and the bond becomes popular and being sold at a premium on its face value. Thus, the general assumption is that the bond prices vary inversely with changes in market interest rates. Bond Pricing Theorems.
Five Fundamental Principles –
Burton G. Malkiel identified the relationship between bond prices and changes in market interest rates. He stated five fundamental principles to relate bond prices and market interest rates which are known as bond pricing theorems.
These are discussed as:
- Bond prices move inversely to market interest changes.
- The variability in bond prices and term to maturity are positively related. For a given change in the level of market interest rates, changes in the bond prices are greater for long-term maturities.
- The sensitivity to changes in market interest rates increases at a diminishing rate as the time remaining until the bond’s maturity increases.
- Absolute increases in market interest rates and subsequent bond price changes are not symmetrical. For a given maturity, a decrease in market interest rate causes a price rise that is larger than the price decline resulting from an equal increase in market interest rate.
- Bond price volatility is related to its coupon rate. The percentage change in a bond’s price due to a change in the market interest rate will be smaller if its coupon rate is higher.
The amount of price variation necessary to adjust to a given change in interest rates is a function of the number of years to maturity. In the case of long-maturity bond, a change in market interest rate results in a relatively large price change when compared to a short-maturity bond. Long-term bond is more sensitive to interest rate changes than short-term bond. This is why short-term bonds generally possess less exposure to interest rate risk. Theorems of Bond Pricing.