Question

What is the relationship between interest rate risk and bond’s coupon rate?

Answer 1

Interest rate risk is a phenomenon which states that when market interest rate rises, prices of fixed rate bonds fall.

For example,

A 5 year fixed coupon bond is issued in the current year with a coupon rate of 5% when the market rate was also 5%. Then we say that the bong will be trading at its face value.

Now consider a scenario after 1 year where the coupon rate is still 5% and the market rate reduces to 4%. Here, the bond is giving higher return compared to market which increases its value as the cash flows from a bond are discounted using market rate.

Now if the market rate rises to 6% whereas the coupon rate is still 5%, which means that bons is giving less return compared to the market return which decreases its value.