Final answer:
Changes in interest rates affect bond prices, and to compensate investors for this risk, a higher coupon rate is offered. The higher coupon rate compensates for interest rate risk by providing a buffer through greater cash flow to investors.
Step-by-step explanation:
The question addresses how changes in interest rates affect bond prices and what compensates bond investors for this risk. Among the listed options, the one that compensates for interest rate risk is a higher coupon rate. A higher coupon rate provides a greater cash flow to the investor, which can offset the impact of a market rate increase on the value of the bond. In contrast, a lower coupon rate would not compensate for interest rate risk, while shorter maturity decreases the time horizon of exposure to interest rate changes. Longer maturity typically increases the risk of adverse effects from interest rate fluctuations.
Understanding how bonds function is key to answering this question. Bonds are a form of debt securities where the issuer owes the bondholders a debt and is obligated to pay interest (the coupon) and repay the debt at the maturity date. If interest rates in the economy rise after a bond is issued, the price of the bond generally falls, as newer bonds may offer higher returns due to these increased rates. Consequently, a bond with a higher coupon rate becomes more attractive to investors, as it provides a buffer against these interest rate changes.