Bond Price

When market interest rates rise, the prices of existing bonds:

1. A.FallCorrect - the inverse price/yield relationship.
2. B.RiseIf existing bonds rose alongside rates, no one would buy the higher-paying new issues instead. Older bonds must fall in price until their yield is competitive with what the market now offers.
3. C.Stay the sameA bond with a below-market coupon cannot hold its price, because buyers have better alternatives available. Only an instrument whose coupon resets, such as a floating-rate note, comes close to staying put.
4. D.Become fixedThis confuses the coupon with the price. The interest payment is fixed at issuance and does not change, but the price at which the bond trades adjusts continuously to market conditions.

Why: Bond prices move inversely to interest rates, so rising rates push existing bond prices down.

If market interest rates rise, what generally happens to the prices of outstanding bonds?

1. A.They fallCorrect — prices and rates move inversely, because the coupon on an outstanding bond is fixed.
2. B.They riseThis assumes prices follow rates. The relationship is inverse, not direct.
3. C.They are unaffected, because the coupon is fixedA fixed coupon is precisely why the price must move — the price adjusts so the yield matches the market.
4. D.They rise for corporate bonds and fall for government bondsThe inverse relationship applies to all fixed-income securities regardless of issuer.

Why: Bond prices and market interest rates move inversely. When newly issued bonds carry higher coupons, existing lower-coupon bonds must sell at a discount to offer a competitive yield.

An investor is most concerned that rising interest rates will reduce the market value of her long-term bond holdings. This concern is an example of...

1. A.Liquidity riskLiquidity risk is about the ease of selling, not rate-driven price changes.
2. B.Purchasing-power riskPurchasing-power risk is about inflation eroding real value, not rate-driven price drops.
3. C.Credit riskCredit risk concerns issuer default, not the effect of changing rates on price.
4. D.Interest-rate riskCorrect — rising rates pushing bond prices down is interest-rate risk.

Why: The risk that rising rates push existing bond prices down is interest-rate risk, which is greatest for long-maturity, low-coupon bonds.

Two bonds have the same yield. Bond X has a 3% coupon maturing in 20 years; Bond Y has an 8% coupon maturing in 5 years. If market interest rates rise by 1%, which bond's price falls more, and why?

1. A.Bond Y, because higher-coupon bonds are always more price-volatileIncorrect. Higher coupons reduce duration, making Bond Y less sensitive, not more.
2. B.Both fall equally, because they have the same yieldIncorrect. Equal yield does not imply equal duration or equal price sensitivity.
3. C.Bond X rises, because low-coupon bonds move inversely to rate increasesIncorrect. All bond prices fall when rates rise; Bond X does not rise.
4. D.Bond X, because its longer maturity and lower coupon give it greater duration and more price sensitivityCorrect. Longer maturity and a lower coupon raise duration, so Bond X falls more.

Why: Bond X falls more. Its longer maturity and lower coupon give it a greater duration, which measures price sensitivity to interest-rate changes. A longer term to maturity and a smaller coupon both increase duration, so Bond X is the more rate-sensitive of the two. All bond prices fall when rates rise.