NASAA Series 66 Uniform Combined State Law ExaminationEconomic Factors and Business InformationMedium
A client expresses concern about the potential for their bond portfolio to lose value if interest rates were to unexpectedly rise. Which type of risk is the client primarily worried about?
- ALiquidity risk.
- BInflation risk.
- CCredit risk.
- DInterest rate risk.
Show answer & explanationAnswer & explanation
Correct answer: D. Interest rate risk.
Interest rate risk is the risk that the value of a bond or other fixed-income investment will decline due to a rise in market interest rates. As rates rise, existing bonds with lower coupon payments become less attractive.
Why the other options are wrong
- A. Liquidity risk is the risk that an investment cannot be quickly converted into cash without a significant loss in value, which is not the client's primary concern.
- B. Inflation risk is the risk that the purchasing power of an investment's returns will be eroded by rising prices, which is distinct from the described concern about bond value changes due to rate hikes.
- C. Credit risk is the risk that the issuer of a bond will default on its payments, which is not the concern described.
Interest Rate Risk
The risk that a bond's value will decline due to an increase in prevailing interest rates.
- Inverse relationship with bond prices.
- Longer maturity bonds are more sensitive.
- Lower coupon bonds are more sensitive.
Memory trick: Interest Rates Rise, Bond Prices Dive.