Securities Industry Essentials (SIE) ExamKnowledge of Capital MarketsHard
A client is interested in purchasing a security that provides regular income and has a stated maturity date, but they are concerned about interest rate risk. Which of the following statements about bonds and interest rate risk is TRUE?
- AZero-coupon bonds are more sensitive to interest rate changes than coupon bonds of similar maturity.
- BShort-term bonds are more sensitive to interest rate changes than long-term bonds.
- CWhen interest rates rise, existing bond prices typically increase.
- DBonds with higher coupon rates are more sensitive to interest rate changes.
Show answer & explanationAnswer & explanation
Correct answer: A. Zero-coupon bonds are more sensitive to interest rate changes than coupon bonds of similar maturity.
Zero-coupon bonds are more sensitive to interest rate changes because their entire return is realized at maturity, making their duration equal to their maturity. Coupon bonds have a shorter effective duration due to interim payments.
Why the other options are wrong
- B. Long-term bonds are more sensitive to interest rate changes due to their longer duration.
- C. When interest rates rise, existing bond prices typically fall to adjust their yield to the new market rates.
- D. Bonds with lower coupon rates (or zero-coupon) are more sensitive to interest rate changes because more of their return is weighted towards maturity.
Interest Rate Risk (Bonds)
Interest rate risk is the risk that changes in market interest rates will affect the value of a bond.
- Inverse relationship: rates up, prices down; rates down, prices up.
- Longer maturities (duration) mean higher interest rate risk.
- Lower coupon rates (duration) mean higher interest rate risk.
Memory trick: Interest Rate Risk: 'Inverse' to prices, 'Long' duration, 'Low' coupon.