A security with higher risk will have a higher expected return. A bond\'s risk l

Question

A security with higher risk will have a higher expected return. A bond's risk level is reflected in its yield, but understanding the different risks involved when investing in bonds is important. The curves on the following graph show the prices of two 10% annual coupon bonds at various interest rates. BOND VALUE (S 2000 1750 1500 1250 1000 750 500 250 1-Year Bond 10-Year Bond 12 16 20 INTEREST RATE [96] Based on the graph, which of the following statements is true? O The 1-year bond has more interest rate risk. O Neither bond has any interest rate risk. Both bonds have equal interest rate risk. O The 10-year bond has more interest rate risk.

Explanation / Answer

Solution 1:

Correct option is 4th option > The 10-year bond has more interest rate risk

Longer term bond remains uncertain about interest rate fluctuation and interest in long term can go unfavorable for values of bond. The longer period bond has longer discounting period and it is vulnerable to the adverse interest rate changes which can finally lead to lower price or present value for bonds hence correct option is, The 10-year bond has more interest rate risk.

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Solution 2:

Frank Barlowe is retiring soon, so he is concerned about his investments providing him steady income every year. He is aware that if interest rates Increases, the potential earnings power of the cash flow from his investments will increase. In particular, he is concerned that a decline in interest rates might lead to Reinvestment rate risk annual income from his investments. What kind of risk is Frank most concerned about protecting against?

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Solution 3:

True: Assuming all else is equal, long-term securities are exposed to higher interest rate risk than short-term securities.

Reason: For long term securities are exposed to uncertain interest rate because interest rate can go adverse and which can impact price of security.

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