Question

bond a and bond b are 6% coupon bonds, and have a 7% ytm, and pays annually. bond a is 1 year from maturity and bond b is 3 years from maturity. based on your answers, what does this problem tell you about interest rate risk? group of answer choices as interest rates increase, bond prices decrease. as interest rates decrease, bond prices increase. the lower the coupon rate, the greater the interest rate risk and this is reflected in duration. the greater the time to maturity, the greater than interest rate risk and this is reflected in duration.

Answer 1

Interest rate risk involves the influence of market interest rate changes on bond prices. Bonds with longer maturities are more sensitive to interest rate changes, hence they face greater interest rate risk. Bond B, with a longer maturity than Bond A, exhibits greater sensitivity to interest rate changes due to a higher duration.

Step-by-step explanation:

The question asks us to compare two 6% coupon bonds, both with a 7% yield to maturity (YTM) that pay interest annually, but with different times to maturity; one year for bond A and three years for bond B. This scenario provides insights into the concept of interest rate risk. Interest rate risk is the risk that changes in market interest rates will affect the value of a bond. If interest rates increase, the prices of existing bonds typically decrease because new bonds may be issued with higher rates, making the old bonds less attractive. Conversely, if interest rates decrease, existing bonds with higher interest rates become more attractive, and their prices increase.

Bond A, with only one year to maturity, will be less affected by interest rate changes than Bond B, which has three more years to maturity. This is because Bond B has a longer duration, a measure of the sensitivity of a bond's price to interest rate changes. Therefore, the greater the time to maturity, the greater the interest rate risk, confirming the statement that duration reflects interest rate risk.