Final answer:
Bond prices inversely react to changes in interest rates, with prices decreasing when rates rise and increasing when rates fall. The lower the bond's coupon rate compared to the market rate, the greater the price volatility or interest rate risk.
Step-by-step explanation:
The question deals with understanding how bond prices are affected by changes in interest rates, particularly focusing on bonds with different coupon rates. We are given that both bonds have a yield to maturity (YTM) of 9% and mature in 12 years, but the coupon rates are different (7% for Faulk Corp. and 11% for Yoo Company).
When interest rates rise by 2%, the bond prices will decrease because the existing bonds' fixed coupon payments become less attractive compared to the new bonds that can be purchased with higher interest rates. Conversely, if interest rates fall by 2%, the bond prices will increase because the existing bonds' fixed coupon rates become more attractive relative to the new bonds with lower rates. To calculate the percentage change in the price of the bonds, we would need to consider the coupon rate, the number of remaining payments, and the change in the yield to maturity due to the shift in market interest rates.
The example provided with an 8% coupon rate indicates that when interest rates rise, the bond price falls, and when they fall, the bond price rises. This illustrates the concept of interest rate risk, which is higher for bonds with lower coupon rates. The lower the coupon rate relative to the market rate, the more the price will change in response to fluctuations in the market interest rates.