NASAA Series 65, Uniform Investment Adviser Law ExaminationInvestment Vehicle CharacteristicsMedium
A client holds a bond portfolio and is concerned about the potential for rising interest rates to negatively impact the value of their existing bonds. They want to protect their portfolio from significant capital losses due to interest rate fluctuations. Which of the following strategies or bond characteristics would best mitigate this risk?
- AInvesting in long-duration bonds.
- BFocusing on bonds with high coupon rates.
- CUtilizing interest rate swaps.
- DDiversifying across various credit qualities.
Show answer & explanationAnswer & explanation
Correct answer: C. Utilizing interest rate swaps.
Interest rate swaps allow investors to exchange fixed interest payments for floating interest payments, or vice versa, effectively hedging against adverse interest rate movements.
Why the other options are wrong
- A. Long-duration bonds are more sensitive to interest rate changes, increasing interest rate risk.
- B. High coupon rates can provide more income, but do not directly mitigate the capital loss from rising rates on existing bonds.
- D. Diversifying credit quality addresses credit risk, not interest rate risk.
Interest Rate Swaps
A derivative contract where two parties agree to exchange future interest payments based on a notional principal amount, often used to hedge interest rate risk.
- Exchanges fixed for floating interest payments (or vice-versa).
- Used to manage interest rate risk.
- A type of derivative security.
Memory trick: Interest Rate Swaps 'swap' your rate worries away.