The prices of financial securities are significantly influenced by the prevailing market interest rate. There is an inverse relationship between the prices of financial securities especially bonds and stocks and the prevailing interest rates. This implies that an increase in the interest rates will result in a decrease in the prices of bonds and stocks while a decrease in the prevailing rate of interest will result in an increase in prices of bonds and stocks.
When bonds are issued, they normally have a coupon rate that is equal to or close to the market interest rate prevailing at that time. Usually, the coupon rate of a bond remains fixed until the bond matures. Assuming that the Federal Reserve unexpectedly raises interest rates, the prevailing market interest rate will also rise. In this case, the prevailing market interest rate will be higher than the market interest rate that existed when the bonds were issued. This will result in a decline in the price of bonds. This is because investors will expect new bonds to be issued with a higher coupon rate that reflects the increase in the market interest rates. This will make outstanding bonds to be generally less attractive unless they can be purchased at a lower price.
Similarly, alternative investments with returns that adjust to reflect the prevailing market interest will be more attractive when interest rates increase. Examples of such investments include savings accounts and money markets deposits. This is because investors will be able to earn a higher return by investing in those securities. Investors will therefore sell-off their stocks and bonds. With supply outstripping demand, the prices of bonds and stocks will naturally fall.
The statement "I bought a stock for $30 a share. It is now selling for $20 per share. I have not lost anything because I have not sold it yet" is a fallacy. This is because the investors has unrealized capital losses. Unrealized capital losses occur when the current market value of an investment is lower than the cost an investor incurred to acquire the asset while the investor is still holding onto the investment. It is also referred to as a paper loss since it has not yet been realized.
Investors may be under the illusion that they have not made any losses when the prices of financial securities fall below the price they purchased them at. This is because there is a possibility of erasing the paper loss when prices rise again. This is especially so when investors expect the market to be bullish in the future. However, unrealized capital losses represent a reduction in the net worth an investor. This may be costly for an investor in several ways.
The first cost is opportunity costs. An investor experiencing paper losses may not be able to liquidate his or her investments to take advantage investments with higher returns that may arise. This is because the investor will want to hold on to their current investments until they erase all paper losses before disposing them. Secondly, unexpected emergencies that require cash may arise forcing the investor to sell his or her assets and hence realizing the capital loss. Lastly, since paper losses reduce the net worth of an investor it may limit the amount they can borrow from financial institutions using the financial securities as collateral. This may force the investors to abandon profitable projects due to lack of funds.
References
Banks, E. (2010). Finance: The Basics (2, illustrated ed.). New York: Taylor & Francis.
Emery, D. R., Finnerty, J. D., & Stowe, J. D. (2007). Corporate Financial Management (3rd Ed ed.). New Jersey: Pearson/Prentice Hall.
