Question

If interest rates on bank deposits are 3 percent, would we expect the yield of the bond to be greater than, less than, or equal to 3 percent?

A) Greater than 3 percent
B) Less than 3 percent
C) Equal to 3 percent
D) Not determinable

What will the market price of the bond be, given the yield?
A) Face value of $1,000
B) Less than $1,000
C) Greater than $1,000
D) Insufficient information

One day later, interest rates on bank deposits suddenly decrease from 3% to 2%. What would the bond’s yield adjust to?
A) 3%
B) 2%
C) Greater than 3%
D) Insufficient information

What is the new price of the bond, given the adjusted yield? Does the price of the bond increase or decrease? Explain intuitively why this is the case.
A) Increased; Lower interest rates increase bond prices
B) Decreased; Lower interest rates decrease bond prices
C) Increased; Lower interest rates decrease bond prices
D) Decreased; Lower interest rates increase bond prices

Answer 1

The yield of a bond is expected to be greater than bank deposit rates due to higher risk. When the market interest rate decreases, bond prices generally increase because the bond's fixed interest payments become more valuable relative to the lower yield of new issues.

Step-by-step explanation:

The yield of a bond refers to the return an investor can expect to obtain if the bond is held until maturity. If bank deposit rates are at 3 percent, investors would typically require a yield on a bond to be greater than 3 percent (Answer: A) to compensate for the bond's higher risk compared to a bank deposit. Consequently, when yields are higher than the coupon rate, the market price of the bond is expected to be less than $1,000, i.e., at a discount (Answer: B), because investors require a higher return for taking on the additional risk.

If bank deposit interest rates fall from 3% to 2%, the bond's yield does not automatically adjust to these rates; however, due to the inverse relationship between yield and bond prices, investors might be willing to accept a lower yield on existing bonds since new issues would offer lower interest rates. Thus, we cannot determine the exact new yield without more information (Answer: D). But we can say that the price of the bond will increase (Answer: A) as investors are now willing to pay more for a bond that provides a higher yield than new issues (which will be around 2% following the rate cut).

Understanding bond valuation is crucial when considering fluctuations in market interest rates. A decrease in market interest rates generally leads to an increase in bond prices, and conversely, if market interest rates rise, bond prices typically decrease. This relationship is due to the fixed interest payments that bonds provide; when the market interest rate is lower, these fixed payments are more valuable, thus driving up the price of the bond.