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Bond Pricing and Inflation
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Bond Pricing and Inflation rates
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At their base, interest rates reflect the risk of lending money (Heakal, 2009). Different risk levels are assigned different rates more risk equates to a higher rate. In bond pricing, the firm-specific risk is assigned a particular value, and this is reflected in the price of the bond relative to par. The other risk, which is reflected in the discount rate, is the risk associated with the economy
The reason this risk is considered to be broad economic risk is that it reflects the rate at which the cash flows can be reinvested. This is taken to be a basic government rate. The reason is because government securities are considered to be risk free. If a risk-bearing security was assumed to be the source of the reinvestment rate, then we would be unable to derive a fair value for the bond. Each investor would have a different rate that is used, and the result would be a scenario where any given bond could have a price that fluctuates wildly. Using a risk-free rate creates a level playing field whereby the true value of those cash flows can be established, allowing for the establishment of a fair price for
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