The Dividend Tax Cut and Interest Rates | |||||||||||||||||||||||||||
[Part 3: The Dividend Tax Cut - How Does This Effect Interest Rates?] | |||||||||||||||||||||||||||
What does any of this have to do with interest rates? Well, the interest rate on a bond is inversely related to the price of the bond, meaning that as one goes up, the other goes down. Consider a discount bond with a maturity length of one-year. Suppose you buy a $100 bond with a maturity length of 1 year for $90. This means that you pay $90 today, and on this date one year from now, you receive $100. The interest rate you get on this bond (formally called the yield-to-maturity) is calculated by:
In this equation r is the interest rate (or yield to maturity), "price" is the price you pay for the bond, and "value" is the amount you get in one year. Now as the price decreases, the interest rate increases. This increase in the interest rate as the price decreases is shown in the following chart for a discount bond with a maturity length of one year.^{1} |
Price | r= | Interest Rate |
---|---|---|
100 | (100 - 100)/100 | 0.00% |
99 | (100 - 99)/99 | 1.01% |
98 | (100 - 98)/98 | 2.04% |
95 | (100 - 95)/95 | 5.26% |
90 | (100 - 90)/90 | 11.11% |
Next page > Part 4: How Does Interest Rate Increases from Bonds Effect You? > Page 1, 2, 3, 4, 5, 6.
(1) There are of course, other types of bonds, such as coupon bonds, with different properties and different maturity lengths. However, the relationship between the price and the interest rate (the yield to maturity) is the same, though the equation to calculate the yield to maturity will be far more complicated.