Securities Industry Essentials (SIE) ExamUnderstanding Products and Their RisksMedium
A client is evaluating a preferred stock investment. The preferred stock has a par value of $100 and pays a fixed annual dividend of $5. If interest rates in the market increase significantly, what is the MOST likely impact on the market price of this preferred stock?
- AThe market price will become more volatile.
- BThe market price will decrease.
- CThe market price will increase.
- DThe market price will remain unchanged.
Show answer & explanationAnswer & explanation
Correct answer: B. The market price will decrease.
Preferred stock, like bonds, pays a fixed dividend. When interest rates in the market rise, the fixed dividend of existing preferred stock becomes less attractive compared to new investments offering higher yields, causing its market price to fall.
Why the other options are wrong
- A. While volatility can occur, the primary and most predictable impact of rising interest rates on fixed-dividend preferred stock is a price decrease.
- C. An increase in interest rates generally makes fixed-income investments less attractive, leading to a decrease in price.
- D. The market price of preferred stock is inversely related to interest rates, similar to bonds, so it will change.
Preferred Stock and Interest Rate Sensitivity
Preferred stock, with its fixed dividend, behaves similarly to a bond in its sensitivity to interest rate changes.
- Fixed dividend payments
- Market price is inversely related to interest rates
- When interest rates rise, preferred stock prices fall
- When interest rates fall, preferred stock prices rise
Memory trick: Preferred stock, like a bond, feels the interest rate trend.