Interest-rate Risk

A representative explains that two bond risks pull in opposite directions as rates move. Which pairing correctly states which risk bites when rates rise and which bites when rates fall?

1. A.Rising rates create reinvestment risk; falling rates create interest rate risk.Wrong. This reverses the pair, attaching the price decline to the wrong direction of rate change.
2. B.Rising rates create interest rate risk; falling rates create reinvestment risk.Correct. Higher rates push outstanding bond prices down, while lower rates force coupons into less rewarding reinvestments.
3. C.Both risks bite when rates rise, and neither is present when rates fall.Wrong. Falling rates are exactly when reinvestment becomes a problem, so it cannot be absent from that case.
4. D.Both risks bite when rates fall, and neither is present when rates rise.Wrong. Rising rates depress the price of every outstanding fixed-rate bond, so that direction is far from harmless.

Why: Interest rate risk is about market value: when yields rise, an outstanding bond with a fixed coupon must fall in price to stay competitive. Reinvestment risk is about income: when yields fall, each coupon and each maturing principal payment can be redeployed only at a lower rate. Because the two respond to opposite moves, no single rate environment is comfortable for every objective. A holder who intends to keep a bond to maturity is largely indifferent to the price effect but fully exposed to the reinvestment effect.

An investor buys a zero-coupon bond and intends to hold it to maturity. Which risk has she eliminated, and which one remains?

1. A.She has eliminated purchasing power risk and retained reinvestment risk.Wrong. This reverses the pair, and a fixed maturity value is exactly what inflation attacks.
2. B.She has eliminated reinvestment risk and retained purchasing power risk.Correct. With no coupons there is nothing to reinvest, while the single future payment is still eroded by inflation.
3. C.She has eliminated both, because the maturity value is fixed and certain.Wrong. A fixed nominal amount is precisely the exposure inflation targets, so one of the two plainly remains.
4. D.She has eliminated neither, because the bond makes no payments before maturity.Wrong. The absence of interim payments is the very reason one of these risks disappears.

Why: Reinvestment risk arises because cash received before maturity must be put back to work at whatever rate then prevails. A zero-coupon bond pays nothing until maturity, so a holder who keeps it that long never faces that decision and locks in the purchase yield. What she cannot escape is inflation, because the payment at maturity is a fixed number of dollars and a rising price level reduces what those dollars buy. Were she to sell before maturity she would also face substantial interest rate risk, since zeros are the most price-sensitive bonds of all.

Anticipating a sustained tightening, a client wants the holding in her bond portfolio least likely to lose value as yields rise. Which should she prefer?

1. A.A long-maturity zero-coupon bond issued by a highly rated corporation.Wrong. A zero pays everything at maturity, which makes it the most rate-sensitive structure among these four.
2. B.A long-maturity bond carrying a low fixed coupon and no call provision.Wrong. A low coupon over a long life leaves most of the value far in the future, where it reprices heavily.
3. C.A floating-rate note whose coupon resets to a short-term benchmark.Correct. A coupon that resets upward with the market keeps the note's price close to par as yields climb.
4. D.A long-maturity bond trading at a deep discount to its par value.Wrong. A deep discount usually reflects a low coupon and a long life, which is the recipe for sharp price declines.

Why: Price sensitivity to yields grows with the length of time before the holder's cash actually arrives, so long maturities and low or absent coupons are the most exposed. A floating-rate note sidesteps that, because its coupon resets periodically to a short-term benchmark, so the note pays more as rates rise and its price barely moves. The protection covers interest rate risk only, and the note still carries the issuer's credit risk. Were rates to fall instead, the floater would be the disappointing holding, resetting downward while the long bond appreciated.