Question

Which one of the following bonds is the least sensitive to interest rate risk?

1) 5-year; 6 percent coupon
2) 7-year; 6 percent coupon
3) 7-year; 4 percent coupon
4) 3-year; 4 percent coupon

Answer 1

The 3-year; 4 percent coupon bond is the least sensitive to interest rate risk because of its short maturity and coupon rate, making it less affected by fluctuations in market interest rates.

Step-by-step explanation:

The question posed relates to the concept of interest rate risk, which is the risk that changes in market interest rates will affect the value of a bond. The bond that is least sensitive to interest rate risk is the bond with the shortest maturity and the highest coupon. In this case, option 4, the 3-year; 4 percent coupon bond is the least sensitive to interest rate risk.

Bonds with shorter maturities are less sensitive to interest rate changes because there is less time for interest rates to fluctuate and affect the bond's price. Additionally, higher coupon bonds are less sensitive to interest rate risk because the higher coupons provide more income, offsetting the effect of changing interest rates to some extent. Therefore, among the given options, the 3-year, 4 percent coupon bond will have the shortest duration and hence the lowest interest rate risk.