Final answer:
If the interest rate on one-year bonds rises to 10 percent, the price of a 5 percent coupon bond maturing in one year will decrease to yield a competitive rate to new bond issues.
Step-by-step explanation:
If you are holding a 5 percent coupon bond maturing in one year with a yield to maturity of 15 percent, and the interest rate on one-year bonds rises to 10 percent, the price of the bond will decrease. When interest rates rise, it impacts the price of existing bonds inversely. As the market interest rates go up, the attractiveness of bonds with lower coupon rates diminishes, causing their price to fall so that their yield aligns with current market rates.
This happens because investors can get a better rate on new issues, so the bond must be sold at a discount for the yield to maturity to increase to the new market rate. Considering the provided information, if an investor will receive the $1,000 face value plus $80 for the last year's interest payment, and the bond is priced at $964, the yield will be ($1080 – $964)/$964 = 12%. This illustrates that the yield, or total return, involves not just the interest payments but also the capital gains or losses on the bond. Thus, when interest rates go up, older bonds with lower rates must be discounted to compete with new issues