Question

Which of the following presents the correct relationship? As the coupon rate of a bond increases, the bond's:
a. face value increases
b. current price decreases
c. interest payments increase
d. maturity date is extended

EXPLAIN WHY ANSWER IS CORRECT AND WHY OTHERS ARE INCORRECT

Answer 1

Answer is c. interest payments increase

Price of a bond is basically present value of all associated cashflows with bonds - namely periodic coupon payments and maturity (discounted by YTM).

Mathematically the price of bond can be represented as:

where P = price of bond, C = coupon, i = current prevailing yield on bond, M = face value, n = time to maturity.

Here, 'M','C' and 't' are independent variables that are predecided during bond issuance and are not changed by change in any other variable. Hence option a and Option c are ruled out.

As eveident from the mathematical formula, increase in coupon, increases the price of bond. This is also evident from the fact that the PV of coupons would also increase when coupons increase and hence price of bonds would INCREASE on increase in coupon payments. hence option b is incorrect.

Correct option is hence 'c'. As coupon rate would increase, interest payment would also increase (since coupon signifies the interest payment made by the bond issuer on the bond).