SIE Understanding Products and Their Risks Question 32: Answer and Explanation

Question: 32

Which of the following correctly states the typical relationship between a change in the general level of interest rates and a change in the market value of bonds?

• A. When interest rates stay the same, corporate bond values rise and treasuries decline.
• B. When interest rates stay the same, long-term bond values decline and short-term bond values rise.
• C. When interest rates decline, bond values rise.
• D. When interest rates decline, dollar-denominated bonds remain the same and foreign bond values decline.

Correct Answer: C

Explanation:

C: Bond values typically change inversely compared with changes in the general level of interest rates. For example, if a company issues a bond with a 5 percent coupon and the general level of interest rates declines from 5 percent to 4 percent, the market value of the bond will typically rise. The original bond will be paying 25 percent more in interest than a newly issued bond with the same face, or principal, value with a 4 percent coupon. Longer-term bonds typically have a greater percent change in market value than short-term bonds with the same coupon, given the same change in the general level of interest rates. When the general level of interest rates is stable, unlike stated in Choices A and B, bond values typically do not rise or decline in response. In that scenario, changes in bond values would be more likely related to something specific to the issuer, such as a change in its credit rating. Choice D would typically result in dollar-denominated bonds rising. Because the dollar would be decreasing in value, foreign bonds would typically rise.