Changes

Often, bonds are issued by corporations or governments. The issuer offers them for sale at a specified amount (the ''face value,'') often $1000. The issuer promises to pay that amount back on a specific date (the ''maturity''), and to make regular, specified interest payments—often four times a year (''quarterly'')—in the meantime.

Often, bonds are issued by corporations or governments. The issuer offers them for sale at a specified amount (the ''face value,'') often $1000. The issuer promises to pay that amount back on a specific date (the ''maturity''), and to make regular, specified interest payments—often four times a year (''quarterly'')—in the meantime.

For example, someone who buys a $1000 bond in December, 2007, with a five year maturity and a "coupon interest" of 6% per year

For example, someone who buys a $1000 bond in December, 2007, with a five-year maturity and a "coupon interest" of 6% per year

:—pays $1000 to buy the bond in December, 2007

:—pays $1000 to buy the bond in December, 2007

:—receives interest payments of $15 in March, June, September, and December of 2008, 2009, 2010, 2011, and 2012

:—receives interest payments of $15 in March, June, September, and December of 2008, 2009, 2010, 2011, and 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.

So, someone who buys the example bond and sells it before maturity could find that it was worth anywhere from about $900 to $1100.<ref>Obviously, a bondholder who notices that interest rates have dropped and that their bond is worth more than its face value might well ''decide'' to sell it and take the profit.</ref>

So, someone who buys the example bond and sells it before maturity could find that it was worth anywhere from about $900 to $1100.<ref>Obviously, a bondholder who notices that interest rates have dropped and that their bond is worth more than its face value might well ''decide'' to sell it and take the profit.</ref>