Question

Assume that you own a semi-annual coupon bond. If the price of your bond is decreasing, one reason for this is that

A) the Federal Reserve has increased interest rates.

B) the Federal Reserve has decreased interest rates.

C) the face value of the bond has decreased.

D) the firm's credit rating has decreased.

E) the coupon rate of the bond has been decreased.

Answer 1

Market interest rates and bond prices have inverse relationship between each other.

When market interest rates goes up, prices of fixed-rate bonds goes down and Vice-vera. This phenomenon is known as intrest rate risk.

Let us understand it through an example

let’s say a bond offers a 3% coupon rate, and a year later market interest rates increases to 4%. The bond will still pay a 3% coupon rate, but now it will be fare against the new bond which offers 4% coupon rate. The Price of 3% bond will be more likely to Fall as it now fare against 4% Coupon rate. Now the Discounting rate to calcuate the PV of future cash flows will be 4% instead of 3 % making the bond prices fall.

Because of Increase in market rates the Market value of Bond will decrease to $925. (For more details refer the detailed table below to understand how the Market intrest rate induces the fall in Bond market price)

Conclusion : - Therefore option 1 - Federal reserve has increased the intrest rate will be the correct answer.