Bond AA is a 5-year, 6 percent coupon bond. Bond BB is a 12-year, 6 percent coupon bond. Both bonds have a yield to maturity of 3 percent. If the market yield drops by 2 percent, which of the following will happen? Group of answer choices Bond AA will increase in value by more than Bond BB. Bond prices will not be affected by this change. Both bonds will decrease in value by 8.4%. Bond BB will increase in value by more than Bond AA. Both bonds will increase in value by 8.4%.
As per the bonf theorems,
1) The price of a bond is inversely related to the yield to maturity.
In the given problem when the market yield drops, it affects the yield of bonds too and the yield to maturity of bonds will also drops. So, as yield to maturity inversely related to price of a bond, when yield to maturity drops or decrease, price of a bond will definitely increase.
2) Longer the term to maturity of a bond, higher will be its price sensitivity.
In the given problem Bond BB have 12 years of maturity i.e.higher maturity than Bond AA which has 5 years of maturity. So, Bond BB has more price sensitive than Bond AA, that means Bond BB will increase in value by more than Bond AA.
Therefore, from above 2 theorems it is clear that, bonds will increase in value when YT will drop but Bond BB will increase more than Bond AA.
Answer - Bond BB will increase in value by more than Bond AA.
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