Question

The rise and fall of a bond's price has a direct inverse relationship to its yield to maturity, or interest rate. As prices go up, the yield declines and vice versa. For example, a $1000 bond might carry a stated annual yield, known as the coupon of 7 %, meaning that it pays $70 a year to the bondholder. If that bond was bought for $920 , the actual yield to maturity would be 7.61 % ($70 annual interest on $920 of principal). Do you agree with this analysis? Briefly explain.

A. The analysis is partially correct. There is an inverse relationship between bond prices and bond yields, and the rate of return on the coupon payment is higher if the purchase price is lower. The analysis does not take into account the present value equation of calculating a bond yield. The yield to maturity must be calculated without using present value analysis.
B. The analysis is partially correct. There is a direct relationship between bond prices and bond yields, and the rate of return on the coupon payment is higher if the purchase price is higher. However, the analysis does not take into account the present value equation of calculating a bond yield. The yield to maturity must be calculated using present value analysis.
C. The analysis is partially correct. There is an inverse relationship between bond prices and bond yields, and the rate of return on the coupon payment is higher if the purchase price is lower. However, the analysis does not take into account the present value equation of calculating a bond yield. The yield to maturity must be calculated using present value analysis.
D. None of the above.

Answer 1

D. None of the above

Step-by-step explanation:

There exists an inverse relationship between bond yields and bond prices. Higher the bond prices, lower will be the yield. For example a bond pays 10% interest rate on 1000 face value. If bond price is say 1000, the yield is 10%.

In case bond price is 980, the yield would be 100/980 i.e 10.2%. This shows, lower the bond price which is denoted as
`B_(0)`, higher would be the bond yield.

Similarly, there exists an inverse relationship between bond price and interest rate. This means, if the prevailing interest rate in market is higher than the bond's coupon rate of interest, it means investor expectations as denoted by
`K_(d)` would be higher and thus, price of such bonds would be lower.

Hence the given statement is wholly true.