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In this question, start with defining “interest rate risk”. A bond is said to have virtually...

In this question, start with defining “interest rate risk”. A bond is said to have virtually no interest rate risk if the holding periods just equal to the original time to maturity. Then does a coupon bond that satisfies this condition have absolutely no interest rate risk? Why or why not. Explain.

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Answer #1

Interest Rate Risk refers to the risk of a potential decline in investment value due to interest rate fluctuations. There is a negative relation between the interest rate and the price/value of a bond or any other fixed income instrument. Hence if interest rate rises, the price of the bond will fall and vice versa.

As we move towards the maturity of a bond, the interest rate keeps adjusting in such a way that the market value of the bond equals the par value on maturity. Hence, the final cash flow from the bond is certain and known in the last year which further means that there will be no interest rate risk whatsoever.

Factually, as on maturity, Market value of bond= par value of bond

Therefore, we can conclude that a coupon bearing bond will have no interest rate risk if we hold the bond till its original maturity period.

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