Final answer:
The discussion examines how the yield and market price of a bond are impacted by changes in interest rates. A rise in interest rates leads to bonds selling at a discount, while a drop results in a premium. The yield includes interest payments and any capital gains.
Step-by-step explanation:
The subject of the question is related to bonds and their valuation in the context of changing interest rates. Specifically, it concerns how the yield to maturity and the market price of a bond are affected when the prevailing interest rates in the economy change.
When the interest rates rise, existing bonds with lower coupon rates become less attractive and are often sold at a discount to their face value to compensate investors for the bond's lower interest payments compared to new bonds issued at higher current rates. Conversely, when interest rates fall, those existing bonds with comparatively higher coupon rates increase in value, selling at a premium above face value. This gain in value is known as a capital gain, and it, along with interest payments, contributes to the bond's yield or total return.
Thus, if an investor purchases the bond for $964 and receives $80 for the last year's interest payment, plus the $1,000 face value at maturity, the investor's yield would be calculated as ($1080 - $964)/$964, resulting in a 12% yield.