University of Central Florida (UCF) ECO3223 Money and Banking Practice Exam 1

The relationship between interest rates and bond prices is typically inverse. As interest rates rise, the prices of existing bonds tend to fall, and conversely, when interest rates decrease, existing bond prices usually increase.

This inverse relationship exists because when interest rates go up, new bonds are issued at these higher rates, making them more attractive to investors compared to existing bonds that pay lower rates. To remain competitive, the prices of the existing bonds must decrease to offer a yield that matches the new interest-rate environment.

On the other hand, when interest rates decline, the existing bonds that offer higher fixed interest payments become more valuable, increasing their prices. This dynamic illustrates why bond investors are sensitive to changes in interest rates and how these fluctuations directly impact the market value of bonds. Understanding this relationship is crucial for investment strategies in the fixed-income market.