Question

Company ABC is offering bonds to investors to pay for its corporate expansion. Par value: $1,000 per bond Coupon rate: 5 percent per year (fixed rate) Maturity: 10 years If interest rates in the market fell to 3 percent, how would this affect the value of this bond?

Answer 1

If market interest rates fall below the bond's coupon rate, the value of the bond increases. Company ABC's bond, with a 5 percent coupon rate, would be worth more than its $1,000 par value if market interest rates fell to 3 percent, as its higher interest income becomes more attractive to investors.

Step-by-step explanation:

When interest rates in the market fall from the coupon rate at which a bond was issued, the value of that bond generally increases. For Company ABC's bond with a 5 percent coupon and a $1,000 par value, if market interest rates decrease to 3 percent, investors would find the bond more attractive because it pays a higher rate of return than the prevailing market rate. To match the market yield of 3 percent, the bond's price would rise above its par value, as investors are willing to pay more for that higher interest income when compared to newly issued bonds at the current lower rates.

The bond's value can be calculated using the present value of its future cash flows, which include the annual coupon payments and the repayment of the bond's par value at maturity. Since these cash flows are now more valuable compared to the lower interest rates available in the market, their present value increases, which pushes up the bond's price.