Question

You find a five year double A Xerox bond priced to yield 6.00%. Another similar risk five-year F5 Systems bond priced to yield 6.50%. If you expect interest rates to rise; which makes sense:

A. short the f5 system bond , and buy the xerox bond

b. buy the system bon and short the xerox bond

c. short the f5 systems bond and xerox bond

d. buy both the f5 system bond and xerox bond

Answer 1

Sol:

Answer = b. buy the system bond and short the xerox bond.

Rising interest rates cause bond prices to fall and bond yields to rise. On the other hand falling interest rates make bond prices to rise and bond yields to fall. A bond's yield is based on the bond's coupon payments divided by its market price; as bond prices increase, bond yields fall.

When interest rates are low, bond prices increases because investors are seeking a better return. They have to pay more for the bond which leads to decline in yield. On other hand when interest rates are high, bond prices decreases and yield increases.