Question

What is the bond market’s single main mechanism for incorporating risks in bonds?

Answer 1

Interest rates are the most important mechanism in the bond market to determine how risky the bonds are.

• Bonds with higher interest rates are riskier so investors have to be given some incentives to invest in such a bond
• If the interest rate framework is very volatile then the risk of losing on the price of the bond is high as when the interest rate rises, the price of the bond falls so investors who had purchased these bonds earlier lose out
• market interest rates are used to discount the bond;s CFs to price the bonds so bond's CF are exposed to the interest rates.

Therefore movement in the interest rates is the most important factor while determining the risks of a bond