Question

1. Suppose you buy a 7 percent coupon, 20-year bond today when it is first issued. If interest rates suddenly rise to 15 percent, what happens to the value of your bond? Why? Illustrate your explanations with a graph.

Answer 1

Bond valuation is the determination of the fair price of a bond. As with any security or capital investment, the expected value of a bond is the present value of the stream of cash flows it is expected to generate. Hence, the value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate.

If after the date of issue, interest rate increases, future cash flows will now be discounted at a higher rate thereby decreasing the value of the bond. Hence the value of the bond will go deep in discount. Hence price of 7% Coupon 20 year bond will reduce if the interest rate increases to 15%.