Which of the following statements is most correct?
A) Other things held constant, a callable bond would have a lower required rate of return than a noncallable bond.
B) Other things held constant, a corporation would rather issue noncallable bonds than callable bonds.
C) Reinvestment rate risk is worse from a typical investor's standpoint than interest rate risk.
D) If a 10-year, $1,000 par, zero coupon bond were issued at a price which gave investors a 10 percent rate of return, and if interest rates then dropped to the point where rd = YTM = 5%, we could be sure that the bond would sell at a premium over its $1,000 par value.
E) If a 10-year, $1,000 par, zero coupon bond were issued at a price which gave investors a 10 percent rate of return, and if interest rates then dropped to the point where rd = YTM = 5%, we could be sure that the bond would sell at a discount below its $1,000 par value.

Question

Quizplus · Accepted Answer

When interest rates drop, the value of existing bonds with higher coupon rates increase, and investors are willing to pay more to obtain those higher coupon payments. As a zero coupon bond does not have interest payments, its value is solely derived from its discounted future cash flows, therefore as interest rates drop, its value would increase, resulting in a price higher than its $1,000 par value, hence it would sell at a premium over its par value.

Which of the Following Statements Is Most Correct