FINRA Series 7Investment Information and Suitable RecommendationsHard
A client is considering two bonds of similar credit quality: Bond A has a 5-year maturity and a 6% coupon rate, while Bond B has a 10-year maturity and a 6% coupon rate. Both bonds are trading at par. Which of the following statements about their interest rate risk is MOST accurate?
- ABond B has higher interest rate risk than Bond A.
- BNeither bond has interest rate risk as they are trading at par.
- CBoth bonds have the same interest rate risk because their coupon rates are identical.
- DBond A has higher interest rate risk than Bond B.
Show answer & explanationAnswer & explanation
Correct answer: A. Bond B has higher interest rate risk than Bond A.
Bonds with longer maturities generally have higher interest rate risk. This is because their cash flows are spread out over a longer period, making their present value more sensitive to changes in interest rates. Therefore, Bond B, with a 10-year maturity, has higher interest rate risk than Bond A, with a 5-year maturity.
Why the other options are wrong
- B. All bonds, except floating-rate bonds, have interest rate risk, regardless of whether they are trading at par.
- C. Coupon rate affects sensitivity but maturity is a more significant factor for overall interest rate risk.
- D. This is incorrect; longer maturities imply higher interest rate risk.
Interest Rate Risk (Bonds)
Interest rate risk is the risk that a bond's price will decline due to an increase in prevailing interest rates. Bonds with longer maturities and lower coupon rates generally have higher interest rate risk.
- Inverse relationship between bond prices and interest rates.
- Longer maturities = Higher interest rate risk.
- Lower coupon rates = Higher interest rate risk.
- Zero-coupon bonds have the highest interest rate risk for a given maturity.
Memory trick: Longer term, lower coupon, higher rate risk.