The sensitivity of coupon price to change in its yield:
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A. B. C. D.A
The sensitivity of coupon price to changes in its yield is commonly referred to as bond price volatility or interest rate risk. It is an important concept in bond valuation and risk management. The correct answer to the question is B. The sensitivity of coupon price is inversely related to the bond's yield to maturity.
To understand why, let's first clarify some key concepts. The yield to maturity (YTM) of a bond is the total return an investor can expect to earn if the bond is held until it matures. It takes into account the bond's coupon payments, its purchase price, and the time remaining until maturity. YTM is expressed as an annualized percentage.
The coupon price refers to the present value of the bond's future cash flows, including the periodic coupon payments and the final principal payment at maturity. It represents the current market price of the bond.
Now, when the yield to maturity of a bond increases, it means that the bond's expected return is higher. In other words, the bond becomes relatively less attractive compared to other investment options available in the market. When this happens, the price of the bond typically decreases.
Conversely, when the yield to maturity of a bond decreases, it means that the bond's expected return is lower. In this case, the bond becomes relatively more attractive compared to other investment options, and its price tends to increase.
This inverse relationship between yield to maturity and bond price is primarily due to the discounted cash flow (DCF) valuation methodology. Bond prices are calculated by discounting the future cash flows using the prevailing interest rates (yield to maturity). When the yield to maturity increases, the discount rate applied to the bond's cash flows also increases, leading to a lower present value and a lower bond price. Similarly, a decrease in yield to maturity leads to a decrease in the discount rate, resulting in a higher present value and a higher bond price.
Therefore, the sensitivity of the bond's price to changes in its yield to maturity is inversely related. If the yield to maturity changes by a small amount, the bond price will change by a relatively larger amount in the opposite direction.
Answer A is incorrect because the sensitivity of coupon price is not directly related to the bond's yield. Answer C is also incorrect because the sensitivity is typically greater for decreases in yield to maturity (increases in price) than for increases in yield to maturity (decreases in price). Answer D is incorrect because the sensitivity of coupon price is not constant; it varies depending on the magnitude and direction of the change in yield to maturity.