Question

Suppose you buy a 7 percent coupon, 20-year bond today when it’s first issued. If interest rates suddenly rise to 15 percent, what hap-pens to the value of your bond? Why?

Answer 1

The value of our bond will decrease.

• When the rate of interest increases or rises, the value of the existing bonds generally decreases. This happens because the newly issued bonds usually offer higher coupon rates. This makes them more attractive to investors in comparison to older bonds with lower coupon rates.
• The value of any bond is given by the present value of all the coupon payments that a bondholder will receive until the maturity of the bond. This present value is discounted at the rate of interest on the bond.
• When the interest rate rises, there is a decrease in the discounting factor, which in turn decreases the present value of the bond. So, we can say that the value of the bond decreases with a rise in interest rates.
• Therefore, if interest rates suddenly rise to 15 percent, then the value of our bond will decrease.

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