Question

WHY would a 4-year fixed income security promising $100 drop of $8.08 in market value if interest rate rises from 5% to 6%?

Answer 1

The price of fixed income security and interest rates are inversely related to each other, which means a decrease in interest rate would cause the market value of fixed income security to increase and vice versa. Since the interest rate has increased from 5% to 6%, the market value of the fixed income security has dropped by $8.08.

With the increase in interest rate, the other fixed income securities offering the same coupon and having the same maturity looks more attractive than our fixed income security. The demand for our 5% yield security goes down, which pushes the price down until this becomes equally attractive to the one that pays 6%.

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