Stocks and bonds are traded different markets (equity/debt). Interest
rates are set in the debt market.  Why does there seem to be an
inverse relationship between the movement of stock prices and interest
rates?

Dear scarlette123-ga;

Good question. The concept that stock price and interest rates enjoy
an inverse relationship is actually quite theoretical rather than
absolute. An inverse relationship seems to exist between stock prices
and interest rates because interest rates are closely tied to discount
rates, therefore a rise in interest rates do (frequently, but not
always) have a negative impact on stock prices (and vice-versa). The
strange relationship between stocks and interest rates is explained
this way:

?To obtain a fair value, multiply P, the probability that the money
will be paid in the future, by the Present Value of a stock given it's
interest rate (I) over time (T).

$1 / (1 + I)T 

In an ideal world, the price of a stock would equal the present value
(PV) from adding up the expected dividends from each year in the
stock's future.

Because of expected future impact, when interest rate rises 1%, a
stock's price (PV) drops by more than that percentage. Thus, stock
prices and interest rates have an inverse relationship.

Interest rates usually come down at the end of a normal business
cycle, which is also the beginning of the next cycle.?

WILSON MAR.COM
http://www.wilsonmar.com/investing.htm

Put simply, a $20 dividend paying stock in a 10% economy is valued the
same as a $50 dividend paying stock in a 25% economy.  When interest
rates increase we can reasonably expect stocks to drop in price.
Here?s another explanation:

?If the required return rises, the stock price will fall, and vice
versa. This makes sense: if nothing else changes, the price needs to
be lower for the investor to have the required return. There is an
inverse relationship between required return and the stock price
investors assign to a stock.

The required return might rise if the risk premium or the risk-free
rate increases. For instance, the risk premium might go up for a
company if one of its top managers resigns or if the company suddenly
decides to lower its dividend payments. And the risk-free rate will
increase if interest rates rise.

So, changes in interest rates impact the theoretical value of
companies and their shares: basically, a share's fair value is its
projected future cash flows discounted to the present using the
investor's required rate of return. If interest rates fall and
everything else is held constant, share value should rise. That's why
the market cheers when the U.S. Federal Reserve announces a rate cut.
Conversely, if the Fed raises rates (holding everything else
constant), share values ought to fall.?
IT?S IN YOUR INTEREST
http://www.investopedia.com/articles/fundamental/04/061604.asp

This relationship is not unique either. Likewise there seems to be an
inverse relationship between commodities and bonds, and an inverse
relationship between the US Dollar and commodities.

I hope you find that my answer exceeds your expectations. If you have
any questions about my research please post a clarification request
prior to rating the answer. Otherwise I welcome your rating and your
final comments and I look forward to working with you again in the
near future. Thank you for bringing your question to us.

Best regards;
Tutuzdad-ga ? Google Answers Researcher



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Request for Answer Clarification by scarlette123-ga on 04 Nov 2005 05:12 PST

In your opening statement you use the term "discount rate".  I am not
familiar with it.  Also I do not understand how a $20 dividend paying
stock in a 10% economy is valued the same as a $50 dividend paying
stock in a 25% economy. I believe i must be using the wrong formula to
determine the return value if this case is true.

---

Clarification of Answer by tutuzdad-ga on 04 Nov 2005 07:14 PST

A ?discount rate? is the interest rate used to compute the present
value of future cash flows.

What I said here was really an off-the-cuff statement that has little
to do with the answer itself, so don?t be too confused by it. You?re
right though. I misspoke regarding the formula, and I apologize. Let
me see if I can clear it up for you.

What I intended to convey was that a $20 dividend as the result of a
10% increase is the valued the same as a $50 dividend paying at a rate
of 10%. In short, the PROFIT MARGINS are the same.

RATE OF RETURN CALCULATOR
http://cgi.money.cnn.com/tools/returnrate/returnrate.jsp

You can calculate the rate of return on an investment using the following formula:

((Return - Capital) / Capital) × 100% = Rate of Return

Therefore,

(($110 - $100) / $100) × 100% = 10%

Your rate of return is 10%.

I hope this clears up my error.

Tutuzdad-ga

The web site references are what really helped me on this answer.  I
was able to research my own question with those references.

There is also the supply/demand issue.  

If interest rates drop then money is cheaper (people/businesses can
borrow money from a bank cheaply).  This leads to
1) People have more money to invest which drives up demand for stocks
2) Businesses need less money from investors (because they can get it
from banks cheaply) which reduces the supply of stocks (fewer new
issues)

Just to add a bit to tutuzdad's excellent answer.

Stocks and bonds aren't really traded on different markets, they're
just different financial items.

The valuations involve a lot more than interest rates (such as
speculation), although interest rates can serve as a guide.

When you hear that the interest rate has been raised or dropped by the
Bank of England or the ECB, this is done through the repo rate of the
bank.

BBA Benchmarks REPO Rates
http://www.bba.org.uk/bba/jsp/polopoly.jsp?d=228&a=1455

The interest rate of the bank, will help determine the required rate
of return, therefore affect the pricing of bonds, and their yield to
date. If bonds are not interesting, investors will tend to go for
equities and vice-versa. The markets are interrelated.

Bond tutorial
http://www.investopedia.com/university/advancedbond/advancedbond3.asp

If you want to have fun, try and read about how derivatives and
structured products are priced.

A little background: I work for an investment bank and at the
beginning of 2005, we merged Global Equities (used to deal with
stocks) and Global Markets (used to deal with bonds), for several
reasons, but especially cost synergies. Just to illustrate that
they're not that different.

If you have any more questions, I'd be happy to help if I can.

Thanks.
endo