Suppose you bought a bond on October 1, 2015 for $1,000 that pays you interest a

Question

Suppose you bought a bond on October 1, 2015 for $1,000 that pays you interest at 10% annually ($100 per year). The bond you purchased matures on October 1, 2025. Next year, on October 1, 2016, another student buys a bond for $1,000 that matures on the same date as yours. This student, however, earns 8% annually on the bond they purchased ($80 per year). If you try to sell your bond on October 1, 2016, investors will pay you more than the $1,000 you paid for the bond a year ago. Indicate whether the last statement is TRUE or FALSE; and then provide support for your answer.

Explanation / Answer

FALSE.

Both bonds have been purchased at par. So, yield of both bonds is equal to their coupon rate

Current yield of bond purchased on Oct 1 2015 = Coupon rate = 10%

Current yield of bond purchased on Oct 1 2016 = Coupon rate = 8%

In the bond market, a bond with higher (lower) yield will have lower (higher) price, since yield and bond price move in opposite direction.

Therefore, the bond with a 10% yield will have a lower market price.

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