Question

1. Explain why it is the case that bond prices fluctuate in response to changing interest rates.

What adverse effect might occur if bond prices remain fixed prior to their maturity?

2. What is meant by “default risk” in bonds, and how do investors respond to it?
3. Why do bonds exhibit interest rate risk?
4. Why do investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings?
5. How much would an investor lose if she purchased a 30-year zero-coupon bond with a $1,000 par value and 10% yield to maturity, only to see market interest rates increase to 12% one year later?

Answer 1

· Bond prices fluctuate because of the response from the change in interest rate because bonds pay periodic cash flows known as coupon payment and at the maturity it pays the principal value and to calculate the price of the bond we use the market interest rate to discount all the future cash flows to its present value today. So, if the interest rates are high in the market then the present value of the cashflows would be low and if the interest rate are low then the present value of the cash flows would be high.

· If bond prices remain fixed prior to their maturity then it will create a situation of arbitrage where people will buy the bond at its fixed value even if the market value of the bond is higher. This will create a situation of arbitrage and people will buy the bond at the cheap price and selling the bond at higher price.

· Default risk means that the borrower might not be able to repay back the coupon payment or principal payment or both. Investors respond to it by adding default risk premium to it. The required rate on debt increases as default risk increases, it is also known as adding default risk premium.

· Bonds exhibit interest rate risk that means that bond price is sensitive to change in interest rate, it is because we use the market interest rate to determine the price of the bond and as interest rate increases the present value of all the future cash flows decreases and vice versa.

· Credit ratings are a way by which the investor judge the creditworthiness of the issuer and it also helps in determining whether the bond is of investment grade or speculative grade. Generally, BBB and above rating are considered to be investment grade and higher the rating there is low probability that the issuer will default and lower the rating higher is the probability that the issuer will default and hence investors charge default risk premium.

· The price of a zero-coupon bond = Face value/ (1+ Interest rate) ^Time period

Price = 1000/ (1+0.10) ^30 =57.3086

A year later, the maturity period would be 29 years

Price = 1000/ (1+0.12) ^29 = 37.3833

The price has fallen by = 57.3086 – 37.3833 = 19.9253