medium · Principles of Finance valuation
Compare Bond A (10-year, 8% coupon) and Bond B (10-year, 2% coupon), both currently yielding 5%.
If interest rates increase by 100 basis points, which bond will experience the larger percentage price decrease, and why?
- Bond B, because bonds carrying lower coupons exhibit lower convexity, making them far more vulnerable to sudden rate spikes.
- Bond B, because lower-coupon bonds have a higher proportion of their present value in the distant principal payment, increasing duration.
- Both bonds will experience an identical percentage decrease, since they share the same maturity and identical starting yield of 5%.
- Bond A, because its larger coupon payments make its price more sensitive to the discount rate applied in the earliest years of the bond's life.
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