Final answer:
The coupon rate of a bond is calculated by dividing the annual interest payment by the face value of the bond. If market interest rates rise, the value of existing bonds typically decreases to remain competitive with new bonds issued at the higher rates.
Step-by-step explanation:
A bond's coupon rate is equal to the annual interest payment divided by the face value of the bond. The face value, sometimes also referred to as the par value, is the amount the issuer agrees to pay back the bondholder at the maturity date of the bond. The coupon rate indicates the yearly amount of interest paid by the bond expressed as a percentage of the face value.
For example, if the Ford Motor Company issues a bond with a face value of $5,000 and it pays an annual coupon payment of $150, the coupon rate is calculated by dividing $150 by $5,000, which equals 0.03 or 3%. This represents the interest rate Ford is paying on the borrowed funds.
If market interest rates increase, the value of the bond would decrease. This inverse relationship occurs because new bonds would likely be issued at the new, higher interest rates, making the existing bonds with lower coupon rates less attractive to investors unless they can buy them at a discounted price. Therefore, the bond's market value will adjust downward to offer a yield that is competitively attractive in the new market conditions.