Final answer:
If the market interest rate is higher than the bond's coupon rate, the bond's price will be less than its face value. This is because its fixed interest payments are not as competitive as new bonds issued at the higher current rates, and the price must be discounted to reflect the market conditions.
Step-by-step explanation:
The subject of the student's question involves calculating the issue price of a bond given different market interest rates. In the scenario where the market interest rate has increased from the bond's coupon rate, the price of the bond will decrease.
For example, if a company issues a $10,000 ten-year bond at a 6% interest rate, and you are considering buying this bond one year before maturity when the market interest rate is now 9%, you would expect to pay less than the face value because the bond's fixed interest payments are less attractive compared to new issues at the higher current market rate. The calculation would involve discounting the bond's remaining payments (interest and principal) using the new market rate of 9% to determine the bond's current price.
Similarly, if you have a bond with expected payments of $1,080 in its last year (interest plus principal repayment) and the market interest rate is at 12%, the bond's price would be determined by the present value of those payments given the higher market rate. In the provided example, a bond with a face value of $1,000 would be worth less than the face amount—in this case, $964—because the alternative investment can provide the same future value at the prevailing higher interest rate. Thus, the bond must be discounted to the present value that reflects the current market conditions.