Question

A bond sells at a discount when the:
Select one:
a. Contract rate is above the market rate.
b. Contract rate is equal to the market rate.
c. Contract rate is below the market rate.
d. Bond has a short-term life.
e. Bond pays interest only once a year

Answer 1

Answer:

Option A is correct.

Explanation:

The reason is that when the coupon rate is below the market interest rate the borrower will have to compensate for that which he compensates by offering bond at a discount to the lenders. This issuance of bond at a discount is inaccordance with the risk and return relationship. The higher would be the risk the greater would be the return. Not offering return when coupon rate is below the market interest rate, the borrower will have to mitigate for the risk because nobody buy his bonds so the borrower issues bonds at discount so attract investors.

Answer 2

Answer:

C) Contract rate is below the market rate.

Explanation:

A bond is sold at a discount when its market price is lower than its face value (or contract price). This happens when the market interest rate is higher than the coupon rate paid by the bond. Therefore, in order to mach the market rate, the price of the bond must decrease.

E.g. bond's face value = 100, coupon rate = 10%, market interest = 12%

12% x market price = 10% x 100

12% x market price = 10

market price = 10 / 12% = 83.33

the real interest yielded = 10 / 83.33 = 12%