Changes

Why is there any risk at all? The risk arises because bond's principal is locked up until the maturity date. Suppose the purchaser of the bond in the example above discovers in 2010 that he desperately needs his $1000 back, and can't wait until the bond matures in 2012. The bondholder can't actually get his money out, but what he can do is to sell the bond to someone else. This is easy to do, because just like the stock market, there is a bond market and it is highly ''liquid:'' willing buyers are always available. In practice, an ordinary investor just calls his brokerage and says "Please sell thus-and-such bond at the market price." But the market price is uncertain, and depends on the prevailing interest rate, and this is where the risk comes in.

Why is there any risk at all? The risk arises because bond's principal is locked up until the maturity date. Suppose the purchaser of the bond in the example above discovers in 2010 that he desperately needs his $1000 back, and can't wait until the bond matures in 2012. The bondholder can't actually get his money out, but what he can do is to sell the bond to someone else. This is easy to do, because just like the stock market, there is a bond market and it is highly ''liquid:'' willing buyers are always available. In practice, an ordinary investor just calls his brokerage and says "Please sell thus-and-such bond at the market price." But the market price is uncertain, and depends on the prevailing interest rate, and this is where the risk comes in.

To see why this is so, consider the bond example above. Suppose that after three years the bondholder wishes to sell the bond to somebody else. How much is the bond worth? Unlike stocks, there is very little judgement or guesswork involved, just a financial calculation based on the numbers. The bondholder who buys the bond in, say, December of 2010 knows that the bond is going to pay him

To see why this is so, consider the bond example above. Suppose that after three years the bondholder wishes to sell the bond to somebody else. How much is the bond worth? Unlike stocks, there is very little judgement or guesswork involved, just a financial calculation based on the numbers. The bondholder who buys the bond in, say, December 2010 knows that the bond is going to pay him

:—interest payments of $15 in March, June, September, and December of 2011 and 2012

:—interest payments of $15 in March, June, September, and December of 2011 and 2012

:—$1000 when the bond matures in December of 2012.

:—$1000 when the bond matures in December of 2012.

How much should he pay for the bond? This is a standard financial calculation called the [[net present value]] of an income stream. Most spreadsheet programs provide a function for calculating it. It turns out that the calculation depends on one more variable: the interest rate. This bond has a coupon interest rate of 6%. If the prevailing interest rate is 6%, it turns out that the value of the bond is exactly its face value: $1000. In theory, a buyer should be willing to pay $1000 for the bond.<ref>In reality, markets being what they are, the buyer won't be willing to pay quite that much, and the brokerage will definitely want a commission on the trade.</ref>.

How much should he pay for the bond? This is a standard financial calculation called the [[net present value]] of an income stream. Most spreadsheet programs provide a function for calculating it. It turns out that the calculation depends on one more variable: the interest rate. This bond has a coupon interest rate of 6%. If the prevailing interest rate is 6%, it turns out that the value of the bond is exactly its face value: $1000. In theory, a buyer should be willing to pay $1000 for the bond.<ref>In reality, markets being what they are, the buyer won't be willing to pay quite that much, and the brokerage will definitely want a commission on the trade.</ref>  

But if the interest rate is lower than 6%, the bond is worth more than $1000. For example, if the interest rate were '''zero...''' if the buyer was just as happy to get $1000 two years from now as to get it today... then the value of the bond would be just the total value of all of the future payments, or $1120. On the other hand, if the prevailing interest rate is higher than 6%, the value of the bond is less than its face value. For example, suppose the interest rate has risen to 12%, a rather large change. Why would a buyer pay $1000 to receive interest payments of $15 every quarter when he could buy a newly-issued 12% bond and receive interest payments of $30? The net present value calculation shows that the value of the bond is only $894.70.

But if the interest rate is lower than 6%, the bond is worth more than $1000. For example, if the interest rate were '''zero...''' if the buyer was just as happy to get $1000 two years from now as to get it today... then the value of the bond would be just the total value of all of the future payments, or $1120. On the other hand, if the prevailing interest rate is higher than 6%, the value of the bond is less than its face value. For example, suppose the interest rate has risen to 12%, a rather large change. Why would a buyer pay $1000 to receive interest payments of $15 every quarter when he could buy a newly-issued 12% bond and receive interest payments of $30? The net present value calculation shows that the value of the bond is only $894.70.

==Notes==

==Notes==

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