How to Calculate What You're Willing to Pay if the Interest Rate Drops on a Bond

Bond prices rise when interest rates drop.
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In order to be attractive investments, bonds should offer return rates that exceed other interest rates. If a bond's interest rate is no higher than your bank's interest rate, the bond is no better an investment than ordinary savings. Rather than buy the bond, you could just save your money in the bank with no risk. When the bank's interest rate drops, however, the bond will seem a better investment, and you'll be willing to pay more for it.

Step 1

Subtract the original general interest rate from the bond's interest rate, which is listed on the bond certificate. For example, if the Treasury offers a risk-free interest rate of 2.3 percent and a bond offers a 4.1 percent return, subtract 2.3 from 4.1 to get 1.8 percent.

Step 2

Add the drop in the general interest rate. For example, if the interest rate drops by 0.4 percentage points, add 1.8 to 0.4 to get 2.2 percent.

Step 3

Divide this value by 100 and add 1. With this example, add 1 to 0.022 to get a multiplier of 1.022.

Step 4

Raise this multiplier to the power of the number of years until the bond matures. For example, if the bond matures in five years, raise 1.022 to the power of 5 to get 1.115.

Step 5

Multiply the result by the bond's principal. For example, if you're considering a $1,000 bond, multiply $1,000 by 1.115 to get $1,115.

Step 6

Subtract the bond's principal. Continuing the example, subtract $1,000 from $1,115 to get $115. This is the amount you should be willing to pay for the bond to match your alternative profit from a risk-free investment.

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