Interest rates and asset prices

Source: Business Standard

Synopsis: Relationship between interest rates and asset prices is discussed

What is an asset?

An asset is defined as follows,

• a useful thing or an item of property owned by a person or company, regarded as having value.

Interest rate

Interest rate is defined as

• the price one pays to borrow money or the payment one receives when one lends money.

For e.g.: When you take a loan from a bank, you are charged an interest rate that you have to pay to the bank.  Similarly, if you deposit the money in a bank (or we can say, lend money to the bank), you are paid an interest rate.

Relationship b/w asset price & interest rate

Both are inversely related, i.e.

• When interest rate is low, asset prices are high, and;
• When the interest rate is high, asset prices are low.

Let us understand this with an example from bonds, as bonds also are a type of asset.

• Assume that you purchase a bond priced at 100 Rs @ 10% interest rate paid annually for 2 years, meaning the bond shall pay you a payment of 10 Rs every year for 2 years.
• Now, suppose the interest rates go up to 15% the very next day or after a few days.
• You have a friend who also purchased the bond when the interest rate was 10%. He is in need of money and offers you to buy his bond.
• Now, you’ll not buy your friend’s bond for 100 Rs. Why? because the same 100 Rs bond if bought from the open market is giving a 15% interest rate while your friend’s bond is still priced at 10% only. So, you make an offer to your friend that you’ll purchase his bond at 80 Rs.
• Though hesitant, your friend, who is in desperate need of money, accepts your offer.
• Hence, as you can see now, with an increase in interest rate, the bond price went down.