Why do interest rates tend to have an inverse relationship with bond prices?

At first glance, the inverse relationship between interest rates and bond prices seems somewhat illogical, but upon closer examination, it makes sense. An easy way to grasp why bond prices move opposite to interest rates is to consider zero-coupon bonds, which don't pay coupons but derive their value from the difference between the purchase price and the par value paid at maturity. For instance, if a zero-coupon bond is trading at $950 and has a par value of $1,000 (paid at maturity in one year), the bond's rate of return at the present time is approximately 5.26% ((1000-950) / 950 = 5.26%). For a person to pay $950 for this bond, he or she must be happy with receiving a 5.26% return. But his or her satisfaction with this return depends on what else is happening in the bond market. Bond investors, like all investors, typically try to get the best return possible. If current interest rates were to rise, giving newly issued bonds a yield of 10%, then the zero-coupon bond yielding 5.26% would not only be less attractive, it wouldn't be in demand at all. Who wants a 5.26% yield when they can get 10%? To attract demand, the price of the pre-existing zero-coupon bond would have to decrease enough to match the same return yielded by prevailing interest rates. In this instance, the bond's price would drop from $950 (which gives a 5.26% yield) to $909 (which gives a 10% yield). Now that we have an idea of how a bond's price moves in relation to interest-rate changes, it's easy to see why a bond's price would increase if prevailing interest rates were to drop. If rates dropped to 3%, our zero-coupon bond - with its yield of 5.26% - would suddenly look very attractive. More people would buy the bond, which would push the price up until the bond's yield matched the prevailing 3% rate. In this instance, the price of the bond would increase to approximately $970. Given this increase in price, you can see why bond-holders (the investors selling their bonds) benefit from a decrease in prevailing interest rates.

Interest Rates and Bond Pricing

When a bond is issued, it pays a fixed rate of interest called a coupon rate until it matures. This rate is related to the current prevailing interest rates and the perceived risk of the issuer. When you sell the bond on the secondary market before it matures, the value of the bond, not the coupon, will be affected by the then-current market interest rates and the length of time to maturity.

Interest rate risk is the risk that changing interest rates will affect bond prices. When current interest rates are greater than a bond's coupon rate, the bond will sell below its face value at a discount. When interest rates are less than the coupon rate, the bond can be sold at a premium--higher than the face value. A bond's interest rate is related to the current prevailing interest rates and the perceived risk of the issuer. Let's say you have a 10-year, $5,000 bond with a coupon rate of 5%. If interest rates go up, new bond issues might have coupon rates of 6%. This means an investor can earn more interest from buying a new bond instead of yours. This reduces your bond's value, causing you to sell it at a discounted price. If interest rates go down, and the coupon rate of new issues falls to 4%, your bond becomes more valuable, because investors can earn more interest from buying your bond than a new issue. They may be willing to pay more than $5,000 to earn the better interest rate, allowing you to sell it for a premium.

Notice
The call/notice/term money market is a market for trading very short term liquid financial assets that are readily convertible into cash at low cost. The money market primarily facilitates lending and borrowing of funds between banks and entities like Primary Dealers. An institution which has surplus funds may lend them on an uncollateralized basis to an institution which is short of funds. The period of lending may be for a period of 1 day which is known as call money and between 2 days and 14 days which is known as notice money. Term money refers to borrowing/lending of funds for a period exceeding 14 days. The interest rates on such funds depends on the surplus funds available with lenders and the demand for the same which remains volatile.

Call money
Call money is also refereed as inter bank. A short-term money market, which allows for large financial institutions, such as banks, mutual funds and corporations to borrow and lend money at inter bank rates. The loans in the call money market are very short, usually lasting no longer than a week and are often used to help banks meet reserve requirements. While known as an inter bank market, many of the players are not banks. Mutual funds, large corporations and insurance companies are able to participate in this market. Many countries, such as India, are beginning to push for a purification of the call money market, but adding regulations that allow only banks to participate.
A borrower (typically a company) will issue a bond in return for a loan. The bond is the finanicail instrument whereby the issuer promises to repay the loan (the bond face value amount) by a certain date. The bond instrument will state the applicable terms and conditions including the date for repayment and the interest rate. A vanilla bond will be a simple repayment plus interest instrument.