Question

4. Describe interest rate risk and explain what kinds of bonds have more (or less) interest rate risk,

relative to other bonds.

6. Explain why bond values decrease when interest rates rise.

Answer 1

4. The interest rate risk is the risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve, or in any other interest rate relationship

There are two primary reasons why long-term bonds are subject to greater interest rate risk than short-term bonds:

• There is a greater probability that interest rates will rise and thus negatively affect a bond's market price within a longer time period than within a shorter period. As a result, investors who buy long-term bonds but then attempt to sell them before maturity may be faced with a deeply discounted market price when they want to sell their bonds. With short-term bonds, this risk is not as significant because interest rates are less likely to substantially change in the short term. Short-term bonds are also easier to hold until maturity, thereby alleviating an investor's concern about the effect of interest rate driven changes in the price of bonds
• Long-term bonds have greater duration than short-term bonds. Because of this, a given interest rate change will have greater effect on long-term bonds than on short-term bonds.

6 ) Band values decreases when interest rate rises and can be understood from following:

• When interest rates rise, new issues come to market with higher yields than older securities, making those older ones worth less. Hence, their prices go down.
• When interest rates decline, new bond issues come to market with lower yields than older securities, making those older, higher-yielding ones worth more. Hence, their prices go up.