Final answer:
To buy a bond from a dealer, you will pay the asked price. With rising interest rates, the price of existing bonds generally decreases to remain competitive with new bonds issued at higher rates. For a no-risk bond, a price adjustment below face value is necessary for it to be attractive to investors when market rates exceed the bond's rate.
Step-by-step explanation:
When you want to buy a bond from a dealer, the price you will pay is the asked price. This is the price a dealer is willing to sell a bond. The bid price, in contrast, is the price a dealer is willing to buy a bond. Understanding these prices is crucial in bond trading. Considering the change in interest rates, if interest rates go up, the price of a bond typically goes down. This happens because new bonds are likely issued with higher rates, making older bonds with lower rates less attractive, unless sold at a discount. Therefore, if the market interest rate rises above the bond's rate, you would expect to pay less than its face value for the bond.
For example, consider a bond with no risk that pays $80 per year until maturity and has a face value of $1,000. If the market interest rate rises to 12% and there's only one year left until the bond's maturity, the bond becomes an unattractive investment compared to new bonds issued at a higher rate. To make the bond appealing, the seller will lower its price below the face value of $1,000. In this scenario, if you could invest $964 in an alternative investment and receive $1,080 in a year, the bond's price should not exceed $964, since $964 is the present value of $1,080 one year from now at a 12% interest rate.