A bond with no expiration has an original price of $10,000 and a fixed annual interest payment of $1000. If the price of this bond increases by $2500, the interest rate in effect will:
A) Decrease by 1 percentage point
B) Decrease by 2 percentage points
C) Increase by 1 percentage point
D) Increase by 2 percentage points

Question

Quizplus · Accepted Answer

The annual interest payment of $1000 is a fixed amount, so an increase in bond price by $2500 implies a decrease in yield. To calculate the percentage change in yield, we use the formula:
Percentage change in yield = (change in bond price / original bond price) x 100
= (2500 / 10000) x 100
= 25%
Since the bond is a non-expiring bond, the yield is equivalent to the coupon rate, which is the annual interest payment divided by the bond price. Thus the original yield is:
Yield = (1000 / 10000) x 100
= 10%
A 25% decrease in yield is a 2.5 percentage point decrease, so the new yield is:
New yield = 10% - 2.5%
= 7.5%
Therefore, the correct answer is choice B, which represents a decrease in yield by 2 percentage points.

A Bond with No Expiration Has an Original Price of $10,000