Final answer:
The correct answer is that the premium added and the interest rate both increase when a bond's rating decreases due to higher risk. Additionally, if market interest rates rise, the value of existing bonds decreases since new bonds will offer higher rates.
Step-by-step explanation:
When evaluating the relationship between a bond's rating, premium added, and interest rate, we must consider the bond's risk level perceived by investors. A higher-rated bond is considered lower risk, thus typically paying a lower interest rate, because the borrower is deemed more likely to make all payments. In contrast, lower-rated bonds are considered riskier and therefore must offer a higher interest rate to attract investors. This higher interest corresponds to a risk premium and makes the investment's yield more appealing to compensate for the additional risk.
Accordingly, the correct answer is: 2) The premium added increases and the interest rate increases as the bond's rating decreases. This risk premium is an integral part of the interest rate, which also includes compensation for delaying consumption and an adjustment for inflation.
Regarding the scenario of market interest rate changes, if the market interest rate rises after bonds are issued, the value of existing bonds generally decreases. This is because new bonds would be issued at the higher current interest rates, making the older bonds with lower interest rates less attractive, hence reducing their value.