Suppose that a bond promises to pay $107 next year but the interest rate falls from 7 percent to 3 percent per year. How much will the price of the bond be and why?
What will be an ideal response?
At 7% interest the price of the bond would have been $100 because you would need $100 invested at 7% to receive $107 next year. If the interest rate falls to 3% we can use the formula that says the price of the bond is the promised payment divided by one plus the interest rate to calculate that the price would now be $103.88. The price of the bond has risen because at the lower interest rate you would need to invest a larger sum in order to receive $107 next year.
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