Final answer:
The 10-year, zero coupon bond (option 4)is the most sensitive to changes in market interest rates because it has the longest maturity and does not make coupon payments, thus having the highest duration. As market interest rates rise, the bond price would be more volatile since its value is more influenced by the present worth of its future repayment.
Step-by-step explanation:
To determine which bond is the most sensitive to changes in market interest rates, we must consider the bond's coupon rate and maturity. The bond's sensitivity to interest rate changes is known as its duration, and bonds with higher durations are more sensitive to changes in interest rates. Generally, bonds with longer maturities and lower coupon rates have higher durations.
Looking at the options given:
- 5-year, zero coupon
- 5-year, 5 percent coupon
- 5-year, 8 percent coupon
- 10-year, zero coupon
- 10-year, 5 percent coupon
The 10-year, zero coupon bond has the longest maturity and no coupon payments, which suggests it has the highest duration and, therefore, would be the most sensitive to interest rate changes. Zero coupon bonds do not pay periodic interest, which means all their value comes from the principal repayment at maturity. As interest rates rise, the present value of that future payment declines significantly, causing the bond price to be more volatile. Conversely, bonds with frequent coupon payments provide a steady income and tend to reduce sensitivity to interest rate fluctuations because investors are regularly receiving some return on their investment.
If the market interest rate rises, the value of existing bonds, such as the ones issued by Ford Motor Company as in the given example with a $5,000 face value and an annual coupon of $150, typically decreases. This is because newer issues offer higher rates to investors, making the existing bonds less attractive. Therefore, if interest rates rose from 3% to 4%, the value of Ford's bond would decrease.