Final answer:
Bond A trades at a premium because its coupon rate is higher than the current market interest rate, offering more attractive payments to investors. Bond B, with its lower coupon rate, trades at a discount, as it is less attractive compared to the prevailing market rates.
Step-by-step explanation:
When assessing whether bonds trade at a premium or a discount, we compare the coupon rate of a bond to the prevailing market interest rate. If the coupon rate is higher than the market interest rate, the bond trades at a premium; if it's lower, the bond trades at a discount.
In this scenario, Bond A has a coupon rate of 10% and Bond B has a coupon rate of 5%. Given that the market interest rate is 7%, Bond A, with its higher-than-market coupon rate, trades at a premium because it offers more attractive payments than newly issued bonds. Conversely, Bond B offers a rate lower than the market, thus it trades at a discount since buyers can find more attractive rates elsewhere.
Therefore, the answer to the question is: a) Bond A trades at a premium but Bond B trades at a discount.