Question

Consider a 20-year bond with an annual coupon of 10%. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 8%. Which of the following statements is correct?

1) The bond should currently be selling at its par value.

2) If market interest rates decline, the price of the bond will also decline.

3) If market interest rates remain unchanged, the bond’s price one year from now will be higher than it is today.

4) The bond is currently selling at a price below its par value.

5) If market interest rates remain unchanged, the bond’s price one year from now will be lower than it is today.

Answer 1

The correct statement is Option 5 "If market interest rates remain unchanged, the bond’s price one year from now will be lower than it is today"

Explanation: The Bond price is calculated by the discounted cash flows of all the earnings that the bond is going to generate over the periods. When the Yield rate is lower than coupon rate, then the value of the bond will be higher than face value as the discount rate we use is yield rate and the present value of bond or discounted cash flow will be higher than face value. but as the years to maturity will approach the gap between the market value and face value will start diminishing.

The bond should be currently selling at higher price than face value, It cannot go below the face value when the coupon rate is higher than yield. Therefore, Options 1 & 4 are wrong and when the interest rate gets lower than the bond price will increase, therefore option 2 is wrong.