Question

Describe the interest rate risk the retiree faces if she purchases 1-year zero coupon bonds and rolls over the investment for the next 4 years.

Answer 1

A Zero coupon bond is a type of a bond that is purchased at a discount to the face value. It bears no coupon payments and pays not interest. It is purchased at a discounted price from its face value and redeemed at face value on the maturity date.

Interest rate risk is defined as the risk that an investor would face when the bond will decline in value over the period due to fluctuations/change in the interest rate in the market. Interest rate risk is applicable only when the investor intends to redeem/sell the bond anytime prior to the maturity date. Since if the investor holds the bond till maturity, he/she is assured of redeeming the bond at its face value.

A zero coupon bond is priced based on the formula =

= Face Value of the bond/(1+r)^n, where n is the number of years to maturity and r is the rate of interest.

In such a scenario, if the rate of interest increases over the period of the bond, then the price of the bond would reduce exposing the investor for the interest rate risk. Rolling over a zero coupon bond every year exposes the interest rate risk in a way that the price at which the bond shall be rolled over/sale price of the first bond could be well below the initial purchase price.

However in the above question, this risk is applicable only if the retiree sells the bond before maturity and rolls it over for another one year. If she decides to hold the bond till maturity (i.e 1 year) and then re-invest the proceeds in another 1 year bond, then there could not be any case of interest rate risk since the maturity amount to be received is fixed.