If the market rate of interest is greater than the contractual rate of interest, bonds will sell
- a discount.
- their maturity value.
- a premium.
- their face value.
The Correct Answer is
a. a discount.
Why a. a discount is the correct answer?
When the market rate of interest is greater than the contractual rate of interest on bonds, they will sell at a discount. This phenomenon is rooted in the relationship between bond prices and interest rates. Bonds are fixed-income securities that pay periodic interest to bondholders.
The contractual rate of interest, also known as the coupon rate, is the fixed interest rate specified in the bond agreement. On the other hand, the market rate of interest, often referred to as the yield or prevailing interest rate, is the current rate of return demanded by investors for similar investments.
When the market rate of interest exceeds the contractual rate of interest, the existing bonds with lower fixed coupon payments become less attractive to potential buyers. Investors seek investments that offer higher returns in line with the current market conditions.
As a result, the prices of existing bonds must decrease to bring their effective yield in line with the higher market rates. This decrease in bond prices results in selling the bonds at a discount.
Now, let’s explore why the other options are not correct:
b. Maturity Value:
The maturity value of a bond is the amount the bondholder receives when the bond reaches its maturity date. It’s typically the face value of the bond. This value is fixed and predetermined when the bond is issued.
Changes in market interest rates do not directly impact the maturity value. Regardless of fluctuations in market rates, bondholders are entitled to receive the face value of the bond at maturity. Therefore, while market interest rates might affect the bond’s price in the secondary market, they don’t alter the maturity value.
c. A Premium:
Bonds sell at a premium when their contractual rate of interest (coupon rate) is higher than the prevailing market rate of interest. In such cases, investors are willing to pay more for the bond to obtain the higher fixed interest payments compared to other available investments.
However, if the market rate of interest surpasses the contractual rate, the bond’s fixed interest payments become less attractive to investors seeking higher yields. Consequently, the bond’s price decreases, and it sells at a discount rather than a premium.
d. Face Value:
The face value of a bond, also known as par value or nominal value, is the amount stated on the bond certificate that the issuer promises to pay the bondholder at maturity. It is a fixed value that remains constant throughout the bond’s life, unaffected by changes in market interest rates.
Even when market rates fluctuate, the face value remains the same. Therefore, the face value does not determine the bond’s selling price in the secondary market when market rates differ from the contractual rate.
In summary, the relationships between market rates and bond prices are crucial to understand. When the market rate of interest exceeds the contractual rate of interest on bonds, they sell at a discount. This is because investors demand higher yields to compensate for the lower fixed interest payments compared to prevailing market rates.
This discounted price adjusts the bond’s effective yield to be competitive with the increased market rates, making it more appealing to potential buyers despite the lower coupon payments.
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