If interest rates fall from 8 percent to 7 percent, which of the following bonds will have the largest percentage increase in its value?
A) A 10-year zero coupon bond.
B) A 10-year bond with a 10 percent semiannual coupon.
C) A 10-year bond with a 10 percent annual coupon.
D) A 5-year zero coupon bond.
E) A 5-year bond with a 12 percent annual coupon.

Question

Quizplus · Accepted Answer

Zero coupon bonds have no coupon payments and rely entirely on changes in interest rates to generate returns. Therefore, a drop in interest rates will have the greatest impact on the value of a zero coupon bond compared to a bond with coupon payments. The longer the maturity of the bond, the greater the impact of the interest rate change. The 10-year zero coupon bond has the longest maturity and no coupon payments, making it the bond with the largest percentage increase in value when interest rates fall.

If Interest Rates Fall from 8 Percent to 7 Percent