Final answer:
The correct answer is that bond prices decrease as interest rates increase. This is due to the inverse relationship between the two, where higher market interest rates make existing bonds with lower rates less attractive. A bond's price adjusts to remain competitive with new issues and to reflect the increased return available elsewhere in the market.
Step-by-step explanation:
The correct statement about the relationship between interest rates and bond prices is: As interest rates increase, bond prices decrease. This relationship is known as an inverse relationship. When the market interest rate rises, existing bonds with lower interest rates become less attractive, resulting in a decrease in their price. For example, if Ford is paying a certain interest rate on borrowed funds through bonds, and market rates increase from 3% to 4%, the value of Ford's bonds will decrease. This happens because new bonds are issued at the higher current market rate, making the older bonds with the lower interest rate less appealing to investors. As a result, the price must decrease to make the bond's effective yield competitive with new issues. The bond's risk is also crucial in determining its price.
If a bond carries no risk, it will likely sell for its face value when issued. However, if market interest rates rise significantly above the bond's coupon rate, the bond becomes less attractive, and the bond seller would have to lower its price to sell it. For example, if there is an 8% bond and the market interest rate rises to 12%, the seller would decrease the bond price below its face value to make it an appealing investment option.