Final answer:
The bond with the lower coupon rate will have the highest interest rate risk because its price is more susceptible to changes in market interest rates compared to a bond with a higher coupon rate.
Step-by-step explanation:
Among two bonds that are identical except for their coupon rates, the one with the lower coupon rate will have the highest interest rate risk. Interest rate risk refers to the susceptibility of a bond's price to fluctuations in interest rates. Bonds with lower coupon rates are more sensitive to changes in market interest rates, meaning their prices will fluctuate more as compared to bonds with higher coupon rates. This is because the fixed income from a lower coupon bond is less attractive when interest rates rise, leading to a greater decline in the bond's price to align its yield with the current market rates.
To illustrate, if interest rates increase, new bonds paying higher interest rates become available, making the lower coupon rate bonds less desirable. Investors would not want to lock their money into a bond with a lower return when they could potentially receive a higher return elsewhere. Therefore, the market price of the lower coupon rate bond would need to decrease to offer a competitive yield to an investor. Conversely, if interest rates fall, the higher fixed income from a lower coupon bond becomes more appealing, and the bond's price can increase accordingly. As such, lower coupon rate bonds exhibit more price volatility in response to interest rate changes compared to higher coupon rate bonds.