Question

Companies raise capital to finance their capital expenditures and their operations. Investors who purchase common equity (common stock) of a corporation do so in the hope that the company which they have invested in prospers so that this company can afford to pay out cash dividends to its common shareholders, and these common stock investors also hope that as the company prospers the company increases in its market value so that its common equity will be worth more. Investors who purchase the debt (bills, notes, bonds) that a corporation issues hope that the corporation will be able to pay them back both the principal and the interest that has been promised to them, on time and in full. Some companies, mostly corporations, are large enough that their equity and their debt trade in capital markets. In a stock market investors buy and sell common stock and in a bond market investors buy and sell corporate debt. The market price of a corporation’s bonds can vary from day-to-day even when the credit quality of the company which has issued the bonds has not been called into question, even when everyone remains certain that the scheduled payments of principal and interest that a corporation has promised to pay will be made on time and in full. Why? In the absence of default risk

Question 1 options:

	Bond prices move inversely to interest rate movements
	Bond prices move in the same direction as interest rate movements
	Bond prices approach their par values as the time remaining until maturity decreases
	Both a. and c. are correct
	Both b. and c. are correct

Answer 1

Both a. and c. are correct

Price of a bond is the present value of its cash flows. The cash flows are the coupon payments and maturity value, whereas the discount rate is the market interest rate. As market interest rates change, the bond values also change. Higher the market interest rates (discount rate), lower the bond value and vice versa.

As maturity decreases, bond prices approach their par value because there is lower time to maturity (less uncertainty). The price of a bond at maturity has to equal its par value, else there is an inequilibrium.