Which one of these characteristics designates a premium bond? O Coupon rate is lower than current rates O Market price is less than par value O Market price exceeds par value O Coupon rate exceeds inflation rate
The correct answer and explanation is:
The correct answer is: Market price exceeds par value.
Explanation:
A premium bond is one whose market price is higher than its face or par value. This typically happens when the bond’s coupon rate is higher than the prevailing interest rates in the market. Here’s a detailed breakdown of why this is the case:
- Coupon Rate and Market Price Relationship: The coupon rate is the fixed interest rate that the bond issuer agrees to pay to the bondholder. If the bond’s coupon rate is higher than the current market interest rates (also known as the yield), the bond becomes more attractive to investors. In such a case, investors are willing to pay more than the bond’s face value, which results in the bond trading at a premium. For example, if a bond has a coupon rate of 6%, but the prevailing market rates are 4%, investors would find this bond more attractive because it pays a higher return than other bonds available in the market. As a result, the price of the bond will rise above its face value (par value).
- Why Market Price Exceeds Par Value: When demand for a bond increases due to its attractive coupon rate, the market price of the bond increases. This can lead to the bond trading above its face value. Essentially, the bondholder receives more in interest payments than they would with bonds offering lower coupon rates, so the bond is worth more in the secondary market.
- Other Options:
- Coupon rate is lower than current rates: If a bond’s coupon rate is lower than the current market rate, it would likely trade at a discount, meaning its market price would be below par value, not at a premium.
- Market price is less than par value: This refers to a bond being sold at a discount, not at a premium.
- Coupon rate exceeds inflation rate: While this might make the bond an attractive investment, it doesn’t directly indicate a premium bond. The market price depends more on the coupon rate relative to the prevailing market rates, not inflation.
Thus, the defining characteristic of a premium bond is when its market price exceeds par value, which happens when the coupon rate is higher than current interest rates.