Question

What is interest rate (or price) risk? Which bond has more interest rate risk: an annual payment 1-year bond or a 10-year bond? Why?

please explain

Answer 1

We know that bond prices have an inverse relationship with rates. So when rates rise, prices fall and vice versa. Price risk / interest rate risk, is the decrease in bond prices caused by a rise in interest rates.

The longer the security's time to maturity i.e., duration the greater its price volatility i.e., the more its price declines relative to a given increase in interest rates. This happens because the impact of a change in the interest rate environment is larger than it would be for a bond with a smaller duration. In other words as the price is present value of future cash flows, higher rates would mean the discounted value of cash flows further in future would decline at a higher rate. That is, greater the risk that the bond’s value could be impacted by changing interest rates prior to maturity, which may have a negative effect on the price of the bond. Hence, 10 year bond will have higher interest rate risk.