Question

1) Based on your research, explain how the decision of the Federal Reserve Bank (Fed) to raise interest rates would be expected to affect a firm’s cost of capital.

2) In a rising interest rate environment, how would you describe how bond values change over time?

3) As a bond investor, what measures would you take to manage market or interest rate risk?

Answer 1

1) As the interest rates rise, the cost of capital also increases as the firms will now have to pay more to service debt and maintain equity.

2) Bond prices and interest rates have an inverse relationship. Hence, when the interest rates rise, the bond prices will decrease.

3). Interest rate risks can be managed through diversification of the portfolios and invest in a variety of stocks and bonds. Also, taking too much risk can harm the returns through a portfolio and a calculated risk must be taken. Also, longer duration bonds must not be considered when interest rates rise and it is better to invest in mutual funds.