Question 3: (10 points) A1, B1, C1

3) A bond will trade at a discount when its coupon rate is lower than prevailing interest rate as the investors always want a higher yield, they will pay less for a bond with coupon rate lower than prevailing rates, thus they are buying at discount to make up for lower coupon rate. These bonds are sold at for less than its par-or face value. Hence, the market value of the bonds will move in the opposite direction of the change with market interest rates.

Example : Assuming that a corporation issued a 7% $200,000 bond when the market interest rate was also 7% - The bond will be sold for its face value of $200,000. Assume that after the bond had been sold to investors, the market interest rate increased to 8%. The corporation will be paying an interest every six months ($200,000x7%x6/12) = $7,000 to the investor. But with the increase in market interest rate to 8% the interest would be (200,000x8%x6/12) = $8,000 Thus the investor is receiving interest $1,000 every half yearly less than the market interest rate. Hence the bond will be now sold at a discount i.e. the market value of the bond decreases. This clarifies that the market value of an existing bond will move in the opposite direction of the change in market interest rates. When market interest rates increases, the market value of the existing bonds decreases. On the other hand, when the market interest rates decreases, the market value of the bonds increases. The relation between market interest rates and market value of the bond is reversal.