Final answer:
The price of a bond is influenced by market interest rates, default risk, and liquidity risk. A bond will sell below its face value if market interest rates rise above its coupon rate to meet the new yield expectations. The present value of future cash flows from a bond decreases as the discount rate increases.
Step-by-step explanation:
The question involves understanding how a bond's price is affected by various risks, including interest rate risk, default risk, and liquidity risk. A bond's yield to maturity incorporates several components such as the real risk-free rate of interest (r*), inflation premium, default risk premium, liquidity premium, and maturity risk premium (MRP). An investor will require a higher yield to compensate for these risks, particularly if market interest rates rise.
In the scenario with a risk-free bond, it would be issued at par value (typically $1,000) and pay a fixed amount of interest annually. If market interest rates increase, the bond becomes less attractive since new bonds would likely offer higher rates. Thus, the bond's price will decrease to offer a yield that is competitive with the new interest rate environment. For example, if the bond pays an 8% coupon and the market rate is 12%, the price of the bond will be discounted so that it yields about 12% to the new investor.
For a bond with a two-year term and an 8% coupon, the present value is calculated by discounting the interest payments and principal repayment by the appropriate discount rate. If the discount rate is equal to the coupon rate (8%), the bond's present value is equal to its face value. However, if interest rates rise to 11%, the present value will be less than the face value since future cash flows are discounted at a higher rate.