FINRA Series 7Investment Information and Suitable RecommendationsHard
A client is comparing two bonds of similar credit quality: Bond A has a 5-year maturity and a 7% coupon, while Bond B has a 10-year maturity and a 7% coupon. If interest rates are expected to rise significantly, which bond is more sensitive to this change?
- ABond B, because it has a longer maturity.
- BBoth bonds will be equally sensitive because they have the same coupon rate.
- CNeither bond will be sensitive as they are of similar credit quality.
- DBond A, because it has a shorter maturity.
Show answer & explanationAnswer & explanation
Correct answer: A. Bond B, because it has a longer maturity.
Bonds with longer maturities are more sensitive to changes in interest rates than bonds with shorter maturities, assuming all other factors are equal. This is because the present value of future cash flows (coupon payments and principal repayment) is affected more significantly over a longer period. Therefore, Bond B, with its 10-year maturity, will experience a greater price fluctuation than Bond A if interest rates change.
Why the other options are wrong
- B. Coupon rate affects sensitivity, but maturity generally has a more significant impact on interest rate risk.
- C. Credit quality relates to default risk, not interest rate sensitivity. All bonds are sensitive to interest rate changes to some degree.
- D. Shorter maturity bonds are less sensitive to interest rate changes.
Interest Rate Risk / Duration
Interest rate risk is the risk that a bond's value will decline due to rising interest rates. Duration is a measure of a bond's price sensitivity to changes in interest rates.
- Longer maturity bonds have higher interest rate risk.
- Lower coupon bonds have higher interest rate risk.
- Duration quantifies this sensitivity: higher duration means higher sensitivity.
Memory trick: Longer bonds feel the 'wave' of interest rates more.