The market price of bond is simply the present value of all future cash inflows associated with the investment. The present value of future cash inflows is calculated through the redemption value of bond and interest payments spread over the period of time which are then multiplied by the discount factor that is essentially the market rate of interest. Therefore, the following factors determine the market price of bond:
Market Rate of Interest
This is the primary factor that determines the market price of the bond. If the market rate of interest is higher than the bond interest rate, the market value of bond is likely to be lower than the par value. This is because the bond would result in lower cash inflows as opposed to the ongoing market rate of interest. The opposite would be true if the market rate of interest is lower than the bond interest rate; in that case the market value of bond would be higher than the par value. The market rate of interest is taken as the discount factor in the calculation of market value of debt. The higher the market rate of interest is; the lower would be the present value of cash flows associated with the bond.
Redemption value is the cash inflow that would be realized in the last year of investment and therefore impacts the calculation of the market value of bond. The market value of bond is likely to be higher if the redemption value is greater than the par value. Conversely, if the redemption value is equal to par value, the market value of bond is likely to be significantly lower.
Time Period – Term
The market value of bond is also dependent on the time period of investment. This time period determines the number of interest payments that would be received over a period of time. Two similar bonds that pay the same rate of interest are likely to have different market values if the time period till maturity is different; the bond with longer time period is likely to have a higher market value as it results in greater cash inflows over the period of investment. The number of payments would also impact the market value of bond. Semiannual payments are likely to result in a higher market value of bond as the effective rate of interest would be slightly higher than the annual interest rate.
Interest Rate of Bond
This is once again an important factor that determines the market value of bond. The interest rate of the bond determines the annual or semiannual interest payments over the period of time. The higher the interest rate, the greater would be the market value of bond as the interest payments determine the cash inflows over the period of investment and these cash inflows are incorporated in the calculation of market value of bond.
If the rate of inflation is higher than the interest rate of the bond, the market value of bond would be lower than the par value. This is because the bond would not be able to maintain its real value or its purchasing power and therefore would have a lower market value in order to attract potential investors.