Question

Which of the following statements is true about the sensitivity of a bond's price to a change in market interest rates?

1.Inverse Relationship: Bond prices generally have an inverse relationship with market interest rates. When market interest rates rise, bond prices tend to fall, and vice versa.

2.Direct Relationship: Bond prices generally have a direct relationship with market interest rates. When market interest rates rise, bond prices tend to rise, and vice versa.

3.Constant Relationship: Changes in market interest rates have a constant and negligible effect on bond prices, leading to minimal sensitivity.

4. No Relationship: Bond prices and market interest rates are independent, and changes in one do not consistently impact the other.

Answer 1

The true statement about the sensitivity of a bond's price to changes in market interest rates is the inverse relationship: bond prices fall when interest rates rise and vice versa, due to the present value of future cash flows.

Step-by-step explanation:

The statement that is true about the sensitivity of a bond's price to a change in market interest rates is the first one: Inverse Relationship. When market interest rates rise, bond prices generally fall, and when interest rates fall, bond prices tend to rise. The reason behind this is the present value calculation which is used to determine the value of the bond's future cash flows (interest payments) at the current market rates. If the bond's rate is higher than the market rate, it will sell for more than its face value; conversely, if the market rate is higher than the bond's rate, the bond will sell for less.

For example, if a bond is issued at an 8% interest rate and thereafter market interest rates rise to 12%, the bond becomes less attractive since new bonds pay higher interest. Therefore, to induce an investor to buy the original 8% bond, the seller would need to lower its price below the face value. This illustrates the inverse relationship between bond prices and market interest rates.