Final answer:
If the market rate of return is higher than a bond's coupon rate, the bond will sell at a discount, as investors will only purchase the bond for less than its face value to compensate for the lower returns compared to the current market rates. The correct answer is option 2.
Step-by-step explanation:
When the market rate of return exceeds the coupon rate, a bond will sell at a discount. The coupon rate or interest rate of a bond is fixed when the bond is issued and represents the periodic payment that bondholders will receive. However, as market interest rates fluctuate, the value of the bond on the market changes. If the market rate is higher than the coupon rate, investors can get a better return elsewhere, so they will only be willing to buy the bond below its face value to compensate for the lower income stream. Therefore, the bond's present value falls below the face value, and it sells at a discount. Conversely, if the market rate is lower than the coupon rate, the bond is attractive because it pays more than the current market rate, and it will sell at a premium, above its face value. At par, the market rate and the coupon rate are the same, and the bond sells for its face value.