Question

(a) Investor A holds a 10-year bond, while investor B holds an 8-year bond. If the interest rate increases by 1 percent, which investor has the higher interest rate risk? Explain. (b) Investor A holds a 10-year bond paying 8 percent a year, while investor B also has a 10-year bond that pays a 6 percent coupon. Which investor has the higher interest rate risk? Explain.

Answer 1

HI,

HI a bond with more years to maturity has the higher interest rate risk than shorter maturity bond.

We can explain the concept based on coupon remaining to pay. Lets say you hold a bond in which only 2 coupons pending and suddenly interest rate rises than for you only 2 coupons will be affected by this interest rate rise compared to a person for whom 20 coupons remaining.

Hence 10 year bond will have higher interest rate risk.

If the coupon rate is higher than interest rate risk will be lower. The reason is that, with higher coupon rate the bond will pay back its debt faster than the lower coupon rate. So change of interest rate will affect lesser to higher coupon bods than the lower coupon bond.

Hence 6 % a year coupon is having more interest rate risk.

Thanks