The value of a bond is determined as the sum of the present values of its future cash flows, which include periodic coupon payments and the repayment of the principal, or face value, at maturity.
These cash flows are discounted using the yield-to-maturity (YTM) rate, which reflects current market conditions and the bond's risk. The YTM represents the bond's total expected return if held until maturity, assuming all coupon payments are reinvested at the same rate.
A bond's coupon payments provide periodic interest income, typically paid annually or semi-annually, and are calculated as a percentage of the bond's face value. The bond's total value is calculated by adding the present value of its coupon payments to the discounted value of the face amount, which is repaid at maturity. The YTM represents the rate at which the present value of these cash flows equals the bond's market price.
Bond prices and market interest rates are inversely related. When market interest rates rise, the fixed coupon payments of existing bonds become less attractive compared to newer bonds offering higher yields, causing the market price of existing bonds to decrease. Conversely, when interest rates fall, the value of fixed coupon payments becomes relatively more attractive, resulting in higher bond prices.
Understanding the relationship between bond prices, yields, and interest rates is critical for assessing bond investments and their potential returns under different market conditions.
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