NASAA Series 65, Uniform Investment Adviser Law ExaminationEconomic Factors and Business InformationMedium
A market analyst is studying the relationship between interest rates and bond prices. They note that when the Federal Reserve raises interest rates, existing bond prices tend to fall. This observation is best explained by which of the following economic principles?
- AThe inverse relationship between interest rates and bond prices.
- BThe income effect of interest rate changes.
- CThe direct relationship between interest rates and bond yields.
- DThe Fisher Effect.
Show answer & explanationAnswer & explanation
Correct answer: A. The inverse relationship between interest rates and bond prices.
There is an inverse relationship between interest rates and bond prices. When interest rates rise, newly issued bonds offer higher yields, making existing lower-yielding bonds less attractive, thus their market price falls.
Why the other options are wrong
- B. The income effect relates to changes in purchasing power, not directly bond pricing.
- C. While bond yields and interest rates are linked, this option doesn't explain why prices fall.
- D. The Fisher Effect describes the relationship between nominal interest rates, real interest rates, and inflation, not bond price movements due to interest rate changes.
Interest Rate-Bond Price Inverse Relationship
When interest rates rise, the market value of existing bonds falls, and when interest rates fall, the market value of existing bonds rises.
- Driven by the yield differential between old and new bonds.
- Longer maturity and lower coupon bonds are more sensitive.
- Fundamental concept in fixed-income investing.
Memory trick: Interest rates and bond prices are like a seesaw: one goes up, the other goes down.