Suppose that a bond promises to pay its holder $100 a year forever. If the price of the bond increases from $1,000 to $1,250, then the interest rate on the bond
A)rises from 8 percent a year to 10 percent a year.
B)falls from 10 percent a year to 6 percent a year.
C)falls from 10 percent a year to 8 percent a year.
D)rises because the bond becomes a better investment.
E)does not change because the purchaser buys the bond knowing that interest rates will be adjusted.

Question

Quizplus · Accepted Answer

The bond promises to pay the holder $100 a year forever, which means it is a perpetuity. The interest rate on a perpetuity is calculated by dividing the annual payment by the current price of the bond. Initially, the bond was priced at $1,000, so the interest rate was $100/$1,000 = 10%. When the price of the bond increased to $1,250, the interest rate decreased to $100/$1,250 = 8%. Therefore, the answer is C.

Suppose That a Bond Promises to Pay Its Holder $100