Final answer:
The price of a bond increases when its yield to maturity is less than its coupon rate, as it becomes a more attractive investment relative to other bonds with lower yields in the current market.Option A is the correct answer.
Step-by-step explanation:
When a bond's yield to maturity is less than the bond's coupon rate, the price of the bond increases. This is because the coupon rate, which represents the return the bond will pay based on its face value, is higher than what investors could obtain from the market if they were to invest in a new bond. Since the existing bond pays a higher interest rate than what is currently available in the market, it becomes more attractive, leading investors to be willing to pay more for it, which raises its price.
If interest rates in the economy increase (say from 5% to 12%), new bonds are issued that pay higher rates, making the older bonds with lower rates (like our 8% example) less attractive. To compensate, the sellers of the 8% bond would need to lower its price to make it an attractive investment compared to new bonds issued at the higher rates. Conversely, if market rates decrease, the bond's original higher coupon rate becomes more attractive and the bond's price goes up as investors would be willing to pay a premium for it.