Consider the following statements:
1. The price of a bond is inversely related to market interest rates.
2. The yield of a bond is inversely related to its price.
Which of the statements given above is/are correct?
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2
Explanation Statement 1 is correct: The price of bond and market interest rates have an inverse relationship. When market interest rates rise, newly issued bonds offer higher returns.As a result, existing bonds with lower interest rates become less attractive, causing their prices to fall. For example - A bond offering a 7% coupon will lose value if new bonds offer 8%, and gain value if new bonds offer only 6%.
If market rates fall, existing bonds with higher coupon rates become more attractive, so their prices rise.This creates an inverse relationship between bond prices and market interest rates.This creates an inverse relationship between bond prices and market interest rates.
Statement 2 is correct: Yield is calculated based on:
Yield = Coupon Payment divided by Current Market Price of Bond
If bond price falls, and coupon remains fixed, the yield increases
If bond price rises, yield decreases.
Therefore, yield and price move in opposite directions.
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