Final answer:
Financial analysts use the duration of a bond, which is the weighted average time until each cash flow is received, to balance the risks associated with the bond's maturity and coupon rate. Bonds with longer maturities and higher coupons present different types of interest rate and reinvestment risks. Duration helps in understanding a bond's price volatility and interest rate risks.
Step-by-step explanation:
When analyzing the characteristics and risks of bonds, financial analysts pay close attention to two specific aspects: the maturity of the bond and its coupon rate. Long-term bonds tend to have higher interest rate risk, meaning their prices are more sensitive to interest rate changes than short-term bonds. However, they typically have lower reinvestment risk, as the investor doesn't have to find new places to invest this money as frequently. On the other hand, bonds with higher coupons pay more interest, which could be reinvested at potentially lower rates if interest rates fall, representing a higher reinvestment risk but a lower interest rate risk.
The measure analysts often use to account for both a bond's maturity and its coupon rate is called the duration, which is a weighted average of the time it takes to receive each of the bond's cash flows and reflects both price volatility and interest rate risk. Understanding the relationship between face value, coupon rate, maturity date, market interest rates, and a bond's price helps to estimate the present value of the bond, which may differ from its face value.
Interest rates play a significant role in a bond's attractiveness to investors. For instance, if market interest rates fall below a bond's coupon rate, the bond will become more valuable as it presents an opportunity to earn more than the current market rate. Conversely, if market rates rise above the bond's coupon rate, its value will likely decrease.