Final answer:
The question discusses how bonds are priced and the impact of changing interest rates on their value, illustrating the necessity to adjust bond prices below face value when market rates exceed the bond's coupon rate to ensure competitive yields.
Step-by-step explanation:
The question pertains to the concept of bond valuation and pricing in the context of changing interest rates. Bonds are financial instruments that represent a loan made by an investor to a borrower (typically corporate or governmental). When interest rates rise, the value of existing bonds with lower rates decreases, since new bonds are issued at the higher prevailing rate. This phenomenon must be considered when determining the price one should pay for a bond nearing its maturity.
For example, a bond with a face value of $1,000 paying an 8% interest rate is less attractive when new bonds are issuing at a 12% interest rate. Consequently, the seller of the 8% bond would have to lower its price below its face value to make it an equivalently attractive investment to those higher-interest options available in the market.
In another scenario, the same principle applies when looking to purchase a $10,000 ten-year bond with a 6% interest rate one year before maturity when the current market rate is 9%. You would not pay the full face value as the return on the bond would be below the prevailing market rate, and hence, the bond price must be adjusted to provide a similar yield to the investor.