Final answer:
A bond's price is determined in the financial markets and reflects the present value of expected future payments. Variations in market interest rates and the bond's risk will influence its price, which may deviate from face value, especially when market rates exceed the bond's coupon rate.
Step-by-step explanation:
A bond's price (P) is determined in the financial markets and tells us the present value of a stream of future expected payments. This involves considering various factors, including the bond's face value, coupon rate (or interest rate), maturity date, market interest rates, and the risk associated with the bond. If a bond is considered low-risk, it would typically sell for its face value at issuance. However, if market interest rates rise, the bond's price may be adjusted downward to remain attractive to investors, relative to newer bonds offering higher rates.
For example, if a no-risk bond is issued at $1,000, paying $80 per year and interest rates in the economy rise to 12%, investors would not want to buy an 8% bond unless its price is reduced. As a result, to induce an investment into the 8% bond, its price would be lowered below the face value. Therefore, the bond's price reflects the changing market conditions and the perceived risk of the bond.