The market rate of interest falls from 6 per cent to 5 per cent. What happens to the price of an existing bond?
Answer & explanation
Correct answer: option 4
The correct answer is Option (4) → It rises, as the present value of its returns rises.
A bond’s price equals the present value of its returns. When the rate of interest falls, more money is needed today to earn the same returns, so the present value rises. The bond’s price rises with it.
Option (1) It stays at its face value, as the coupon rate is fixed. — Incorrect. The price moves with the present value, not with the face value.
Option (2) It falls, as people now prefer to hold money. — Incorrect. Bond prices rise when the rate of interest falls.
Option (3) It falls, as the present value of its returns falls. — Incorrect. A lower rate makes the present value rise.
Option (4) It rises, as the present value of its returns rises. — Correct. The book’s bond is worth Rs 107.33 at 6 per cent and Rs 109.29 at 5 per cent.
NCERT (2026-27): “The Speculative Motive … Calculation reveals that it is Rs 109.29 (approx.). It means that if you put Rs 109.29 in your savings bank account it will fetch the same return as the bond. … It is clear that under competitive assets market condition the price of a bond must always be equal to its present value in equilibrium. Now consider an increase in the market rate of interest from 5 per cent to 6 per cent. … It follows that the price of a bond is inversely related to the market rate of interest.” |