Question

Tom holds a 5-yr 10%-coupon bond, while his friend Jackson holds a 6- year 8%-coupon bond. They are both concerned about interest rate risk but they do not fully understand how it affects them. Can you help out by providing answers to them on the following questions? What is “interest rate risk”? Which of the two bonds is subject to more interest rate risk? Why?

Answer 1

1. Interest rate risk is the risk that a bondholder will witness losses due to result from change in interest rates. If interest rates rise, for instance, the price of a bond will decline due to sell-off because the market is offering more interest rate than this bond.

2. Bonds having higher maturity and low coupon payments are more vulnerable to the interest rate risk due to its long duration and lower annual coupons. Here, Jackson holds high maturity bond with 6 years and low coupon paymnets (8%).therefore the Jackson bond will have higher interest rate risk.