How do interest rates and Bond prices affect the demand for cash/money?
Bond price is inversely related to the market interest rate
I hear interest rates, and I think, “how much my bank will pay me for parking my money in the bank?” For borrowers, the interest rate decides how much they will have to pay for taking a loan from the bank.
Beyond those two contexts, the interest rate is rarely discussed, but the interest rate is much more than what those two contexts tell you. The interest rate determines whether people are inclined to hold cash or convert cash into assets like landed property, bullion, bonds, etc. For this article, I am placing all assets under the bond category.
What is a bond?
Bonds refer to borrowers issuing certificates to lenders. The certificate mentions the amount borrowed, the interest rate at which the amount is borrowed, the duration of the bond, etc. It’s proof of loan.
The face value and market value
A bond has face value and market value. The face value decides the amount you will get at the end of the bond period, while the market value refers to how much a person will have to pay if they want to buy the bond from the market.
The issuer decides the face value of the bond before they issue the bond, and once the bond is issued, market factors influence the bond value aka. Market value
For example, a firm issues a bond worth Rs 100 and assures a Rs 10 return at the end of the first year and the principal amount (Rs 100) plus Rs 10 at the end of the second year. This bond has a face value of Rs 100, 2 years period, and a coupon interest of 10%.
Present value: Savings account return and Bond return
But as an investor, you would want to compare it with other investment options you have. For example, if your savings bank account has a 5% interest rate, you would compare the bond return with the savings account return.
You would ask how much should I put in my savings account so that at the end of the first year, I get Rs 10.
Let the amount be X. Therefore;
Similarly, how much money do I need to keep in my savings account that gives me Rs 110 at the end of two years. Let this amount be Y.
The present value = X +Y
You need to park Rs 109.29 in your savings account, which will earn you the same return as the bond return.
Any investor will prefer to invest Rs 100 in a bond as the investors get the same return if they keep Rs 109.29 in a savings account. As investors demand bonds, the demand for bonds will rise, thereby; increasing the market value of the bond till its value matches the present value=109.29.
If the bond price goes above the present value?
But if the bond price goes above its Present Value, the bond doesn’t stay the preferred investment. People would want to sell bonds, and the glut of bonds in the market will crash the bond price. In a competitive market, the bond price will be below the present value, or it will be at par with the present value.
Interest rate and the present value
If the interest rate increases to 6%, the present value decreases to Rs 107.33. The Rs 109.29 was the value with a 5% interest rate.
Present value= X+Y
The bond price is inversely related to the market interest rate.
Future movement of bond price and interest rate affects the demand for money/cash
If you expect the interest rate to rise in future, say from 5% to 8%, the bond price will fall. And if you are a bondholder, the decrease in bond price means a loss — similar to a loss you will incur when the market value of the property you are holding plummets. This loss is the capital loss to the Bondholder.
You would want to sell your bond and hold money.
Conversely, when the interest rate is at a peak, you expect the interest rate to fall. People would like to convert money into bonds as they anticipate capital gain (Bond price will rise). The demand for money is low.
Therefore, the future movement of market interest rate and bond price affect the demand for money.