Higher coupon lower interest rate risk

The chapter concludes with a discussion of why banks take interest rate risk and a case study of interest rate risk management. We use cookies to help provide and enhance our service and tailor content and ads. By continuing you agree to the use of cookies. Outline Get Access Get Access. Chapter contents Book contents.

Contemporary Financial Intermediation. Author links open overlay panel. Abstract This chapter takes a deep dive into interest rate risk.


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Because the two amortizing bonds have the same maturity date and the same yield to maturity, the bond selling at a premium must have a higher coupon rate and a higher amount requiring reinvestment and thus higher reinvestment risk. An investor fears that economic conditions will worsen and the market prices of her portfolio of investment-grade corporate bonds will decrease more than her portfolio of government bonds.

A is not correct.

INTEREST RATE RISK

B is not correct. Default risk is the risk that the issuer not making timely interest and principal payments as promised. C is the correct answer. Credit spread risk is the risk that the yield required in the market for a given rating can increase even while the yield on the Treasury security of similar maturity remains unchanged. Thus the investor is concerned about credit spread risk. For an A- rated corporate bond that has deteriorating fundamentals, but is expected to remain investment grade, the greatest risk is most likely :.

Credit spread risk is correct since the bond is expected to see a widening of spreads as a result of deteriorating fundamentals and a potential downgrade but still remaining investment grade. What risk does the bid-ask spread most closely measure :.

by AAII Staff

A is correct. Liquidity risk is the risk that the investor will have to sell a bond below its indicated value. The size of the spread between the bid price and the ask price is the primary measure of liquidity of the issue.

If trading activity in a particular security declines, the bid-ask spread will widen, and the issue is considered less liquid. All else equal , an increase in expected yield volatility is most likely to cause the price of a :. An increase in expected yield volatility increases the values of both put options and call options.

Note here the call option is retained by the issuer.


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  • Note here the put option is owned by the bond holder. Therefore, an increase in expected yield volatility will cause the price of a callable price to decrease and a putable price to increase.

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    Interest Rate Risk - ScienceDirect

    A portfolio of option-free bonds is least likely to be exposed to :. Volatility risk is present for fixed-income securities that have embedded options. Changes in interest rate volatility affect the value of the embedded options and thus affect the values of securities with embedded options. By definition, option-free bonds are not affected by volatility risk.

    Risks associated with investing in bonds Reading 54 Exercise Problems: 1. The investor would then most likely have to sell the bond at: A. Ans : B ; B is correct because the bond would sell below par or at a discount if the yield required by the market rises above the coupon rate. Ans : A ; Since both securities have essentially the same maturity, all else the same, the bond with the lower coupon rate will have a higher sensitivity to changes in interest rates. When interest rates fall, the price of a callable bond will : A.

    Ans : B ; The call feature limits the upside price movement of a bond when interest rates fall. If market interest rates rise, the price of a callable bond, compared to an otherwise identical option-free bond, will most likely decrease by: A. Ans : B ; B is correct. Duration is most accurate as a measure of interest rate risk for a bond portfolio when the slope of t he yield curve: A.

    Ans : C ; C is correct because duration assumes that yields change by the same amount across all maturities. Based on these estimates, the duration of the bond is closest : A. The dollar duration of the bond is closest to : A. Compared with an otherwise identical amortizing security, a zero-coupon bond will most likely have : A.

    Coupon Rate vs Interest Rate

    Ans : B ; Less reinvestment risk : An amortizing security is exposed to reinvestment risk since it receives periodic payments of both interest and principal that must be reinvested ; while a zero-coupon bond has no reinvestment risk since no cash flows are received that must be reinvested before maturity. The reinvestment risk for an investor holding the bonds to maturity is greatest for the bond that is : A. Ans : C ; Reinvestment risk refers to the risk that interest rates will decline causing the future income expected from reinvesting coupon payments to decline.

    Ans : C ; A is not correct. For an A- rated corporate bond that has deteriorating fundamentals, but is expected to remain investment grade, the greatest risk is most likely : A. Ans : C ; Credit spread risk is correct since the bond is expected to see a widening of spreads as a result of deteriorating fundamentals and a potential downgrade but still remaining investment grade. What risk does the bid-ask spread most closely measure : A. Liquidity risk. Credit spread risk. Inflation risk.