Final answer:
The interest rate risk for a fixed-rate bond with a call option is best captured by modified duration, as it accounts for changes in a bond's yield due to interest rate fluctuations. In conjunction with convexity, it provides a greater understanding of the bond's sensitivity to interest rate changes.
Step-by-step explanation:
Understanding Interest Rate Risk for Bonds with Call Options
The interest rate risk of a fixed-rate bond with an embedded call option is best measured by the modified duration. Unlike Macaulay duration, which assumes bond payments are fixed over its life, modified duration adjusts for the change in the bond's yield, making it more suitable for measuring the price sensitivity of a bond due to interest rate changes. Meanwhile, convexity is another measure that takes into account the shape of the price-yield curve and is used in conjunction with duration to provide a more complete picture of interest rate risk. The credit rating is not a direct measure of interest rate risk but an assessment of the issuer's creditworthiness and the likelihood of default.
An investor purchasing a bond is influenced by the rate of return, the borrower's risk, and the economic conditions that may affect interest rates post-issuance. Liquidity is also a factor to consider, as the investor would need to sell the bond to access cash. Modified duration, therefore, plays a critical role in assessing the bond's price volatility in relation to interest rate changes for investors concerned with interest rate risk.