Question

An investor originally purchased a debt security at par value. Unfortunately, the value has fallen to $920 even though the company has reported record earnings. This decline in value would be representative of what type of risk?

A)Credit risk.
B)Interest rate risk.
C)Purchasing power risk.
D)Timing risk.

Answer 1

The decline in the debt security's value is due to interest rate risk, which is caused by rising interest rates that make newly issued bonds more attractive, leading to a price decrease of existing bonds with lower rates to remain competitive.

Step-by-step explanation:

The decline in the value of the debt security from its par value to $920, despite the company reporting record earnings, would be representative of interest rate risk. This type of risk occurs when the interest rates in the economy rise, making newly issued bonds with higher interest rates more attractive than existing bonds with lower rates. As a result, the existing bonds must be sold at a discount to compete with the new higher-yielding bonds, explaining why the investor's security has fallen in value.

For instance, if an investor buys a bond at an 8% interest rate, and new bonds are issued at 12%, the value of the original bond will decrease because it generates less income compared to the new bonds. To sell the 8% bond, the price must be lowered below par value to provide a competitive yield to maturity. This demonstrates the concept of opportunity cost and the present discounted value of future payments, which are adjusted based on the current interest rate.