Question1.7 Consider two bonds, A and B. Both bonds presently sell at their par value of $1,000. Each pays interest of $60 annually. Bond A will mature in 7 years while bond B will mature in 5 years. If the yields to maturity on the two bonds change from 6% to 5%:Select one alternative: None of the above options are correct Both bonds will decrease in value, but bond A will decrease less than bond B Both bonds will increase in value, but bond A will increase less than bond B Both bonds will increase in value, but bond A will increase more than bond B Both bonds will decrease in value, but bond A will decrease more than bond B ResetMaximum marks: 2.5 Flag question undefined

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Question1.7 Consider two bonds, A and B. Both bonds presently sell at their par value of $1,000. Each pays interest of $60 annually. Bond A will mature in 7 years while bond B will mature in 5 years. If the yields to maturity on the two bonds change from 6% to 5%:Select one alternative: None of the above options are correct Both bonds will decrease in value, but bond A will decrease less than bond B  Both bonds will increase in value, but bond A will increase less than bond B  Both bonds will increase in value, but bond A will increase more than bond B  Both bonds will decrease in value, but bond A will decrease more than bond B  ResetMaximum marks: 2.5 Flag question undefined

BlackTom AI · Accepted Answer

First, note the essential setup: both bonds are at par with annual coupon of $60 on a $1,000 par value, so their current yield-to-maturity (YTM) prior to the change is 6%. When YTM falls from 6% to 5%, prices for both bonds will rise because fixed coupon payments become more attractive relative to the new lower discount rate.

Option 1: 'None of the above options are correct.' This would be correct only if neither bond increased in price or if their relative changes contradicted all other statements. Since a drop in yield always raises bond prices (for standard fixed-rate bonds), we should expect price increases, so this option is unlikely to be correct unless there is an unusual detail not present here.

Option 2: 'Both bonds will decrease in value, but bond A will decrease less than bond B.' A decrease in value contradicts the basic bond price-yield inverse relationship when yields fall. Therefore this option is inconsistent with fundamental price behavior and can be ruled out.

Option 3: 'Both bonds will increase in value, but bond A will increase less than bond B.' When yields fall, longer-duration bonds generally experience larger price increases than shorter-duration ones, because their cash flows are discounted over a longer horizon and are more sensitive to interest-rate changes. Bond A has a longer maturity (7 years) than Bond B (5 years), so Bond A should increase more, not less. This makes this option incorrect.

Option 4: 'Both bonds will increase in value, but bond A will increase more than bond B.' This aligns with the standard result: with a drop in YTM from 6% to 5%, both bonds rise in price due to higher present value of future coupons and principal. The longer-maturity Bond A has higher duration and therefore a larger percentage price increase than the shorter-maturity Bond B. Hence Bond A increasing more is the correct qualitative outcome.

Option 5: 'Both bonds will decrease in value, but bond A will decrease more than bond B.' As with Option 2, a decrease in yield-to-murchase generally causes prices to rise rather than fall for standard fixed-rate bonds; this option contradicts the core inverse relationship and is incorrect.

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