A bond with a face value of $1,000 pays a fixed coupon of 5% annually. If market interest rates rise from 5% to 7%, what happens to the bond's market price and why?
AThe bond's price falls to exactly $0, because a bond paying below the current market rate becomes worthless to all investors
BThe bond's price rises above $1,000, because investors prefer the safety of owning a bond that was issued when rates were lower
CThe bond's price falls below $1,000, because newly issued bonds now offer 7% coupons, making the existing 5% coupon less attractive — investors will only buy the older bond at a discount that compensates for the lower coupon
DThe bond's price stays at $1,000, because the coupon rate is fixed and contractually guaranteed regardless of what happens in the broader market
What does a bond's yield to maturity (YTM) represent, and how does it differ from the bond's coupon rate?
AYTM and coupon rate are identical for all bonds trading in the secondary market; the distinction only exists for bonds held from original issuance to maturity
BYTM is the total annualised return an investor will earn if they buy the bond at its current market price and hold it to maturity, assuming all coupons are reinvested at the YTM rate — it accounts for the purchase price, coupon payments, and the return of face value, while the coupon rate is simply the fixed annual interest payment expressed as a percentage of the bond's face value
CYTM is the annual coupon payment divided by the bond's current market price, making it the same as the current yield but expressed on a different time basis
DYTM measures only the capital gain or loss on the bond and excludes coupon income entirely, while the coupon rate captures the income component
An investor must choose between two bonds with identical credit quality and maturity dates: Bond X has a duration of 3 years and Bond Y has a duration of 8 years. If interest rates are expected to rise significantly, which bond carries more price risk and why?
ABond X carries more price risk, because shorter-duration bonds are more volatile since their cash flows are received sooner and are therefore more affected by rate changes
BNeither bond carries price risk because both have fixed coupon payments that are contractually guaranteed regardless of interest rate movements
CBoth bonds carry identical price risk because they have the same credit quality and maturity date, which are the only factors that determine bond price sensitivity
DBond Y carries more price risk, because duration measures a bond's sensitivity to interest rate changes — a higher duration means the bond's price will fall more for a given increase in rates