Understanding Products and Their RisksDifficulty 2/5
Prevailing interest rates rise after an investor buys a fixed-rate bond. What happens to the bond's market price?
- AIt is unchanged, because the coupon payment is fixed until the bond matures
- BIt falls only if the issuer's credit rating is downgraded at the same time
- CIt falls, because the fixed coupon is now less attractive than new issues
- DIt rises, because the fixed coupon is now less attractive than new issues
Show answer and rationale
Correct: C. The inverse relationship between price and interest rates is the most reusable fact in section 2. A bond paying a below-market coupon must be priced down until its yield matches what new issues offer.
- D — The direction is wrong; a below-market coupon makes the bond less valuable, not more.
- A — The coupon is fixed but the price is not; the market reprices the bond to adjust its yield.
- B — Credit downgrades affect price too, but the rate move alone is enough to move it.