0

Does the increase or decrease of the Interest rate (coupon rate) of bonds have the same effect as rising or falling interest rate of the central bank on the economy? In other words when we say that Interest rate is rising or falling then are we referring to the interest rate of the bond or the interest of the central bank?

Improve this question

1 Answer 1

Reset to default
0

"Interest rate" associated with a bond, or more precisely, yield, is not the same as the coupon rate. Coupon rate is the percentage of par/face value of the bond that is paid out periodically. The yield of a bond is the discount rate with which one discounts the cash flows associated with the bond taking into account the timings of the cash flows such that the sum of the discounted cash flows equals the price of the bond. The price and yield of a bond have an inverse relationship.

When they say interest rates are rising, it is the fed funds rate that they are referring to. It is the interest rate which banks charge each other to lend federal funds overnight. This rate influences the general level of interest rates in the market - basically the cost of borrowing money. The Fed raises this rate, for example, when they want to control inflation, by selling its securities to member banks reducing the available funds these banks have for lending to other banks so that they can raise their lending rates owing to money having become scarce. That makes borrowing expensive but controls inflation because people can't borrow easily and spend.

When the Fed wants to stimulate the economy it reduces this rate by buying securities from member banks increasing their available funds for lending forcing banks to reduce their lending rates. This reduces the general level of interest rates, and allows people to borrow more to invest or to spend and stimulates the economy.

Whenever the Fed buys bonds/securities their prices rise, and yields fall, and vice versa. So the Fed uses this buying and selling as a tool to control yields/interest rates.

Improve this answer
51
  • 1
    does this mean the bond pays 10% of the par value periodically? Yes, and it also pays the par/face value of the bond at maturity. If so then how does this differs from the interest of 10%? When you say you get 10% interest from a bank it is on a certain principal that you lend out . In the case of a bond, there is no such fixed principal. Instead, in the arrangement that constitutes the bond the coupon values are fixed because they are a percentage of a fixed face value which is virtual in nature.
    – user2371765
    Jun 5, 2020 at 5:30
  • 1
    Once the coupon values have been determined they first decide what the bond should be worth and THEN solve for the interest rate/discount rate/yield that makes the sum of the discounted present values of the coupons and the final payment equal to the price.
    – user2371765
    Jun 5, 2020 at 5:32
  • 1
    So the yield of a bond is obtained indirectly, but a regular interest rate on a fixed deposit, for instance, is declared upfront and is applied to any given principal.
    – user2371765
    Jun 5, 2020 at 5:34
  • 1
    So coupons are like interest because they constitute periodic payments just like interest on a bank deposit, but the coupon rate is not exactly equivalent to the interest rate.
    – user2371765
    Jun 5, 2020 at 5:36
  • 1
    A simple example of a bond with 1 coupon paid out at 10% coupon rate and par value 100. At maturity, 10 (coupon) +100 (face value) will be paid out and someone is willing to pay 98 for this arrangement. So solve for i in 98 = 110/(1+i) to get i=12.24% which is the yield of the bond. Typically, when the bond makes only one payment it is just of the face value; this was just an artificial example meant to convey how coupon value and yield are calculated.
    – user2371765
    Jun 5, 2020 at 5:40

You must log in to answer this question.

Not the answer you're looking for? Browse other questions tagged .