Explanation
Interest rate risk refers to the sensitivity of a bond's price to changes in interest rates. This risk is measured by duration, with longer duration bonds having higher interest rate risk.
Key Concepts:
- Duration: Measures the sensitivity of a bond's price to interest rate changes
- Coupon effect: Bonds with higher coupons have lower duration
- Price-yield relationship: Premium bonds have higher coupons than discount bonds
Analysis of Each Option:
A. Discount Bond:
- Sells below par value
- Has coupon rate < market rate
- Lower coupon payments → higher duration → higher interest rate risk
B. Premium Bond:
- Sells above par value
- Has coupon rate > market rate
- Higher coupon payments → lower duration → lower interest rate risk
C. Zero-coupon Bond:
- No coupon payments
- All cash flows at maturity
- Highest duration → highest interest rate risk
Duration Comparison:
- Zero-coupon bonds have the highest duration (equal to their maturity)
- Discount bonds have higher duration than premium bonds of same maturity
- Premium bonds have the lowest duration due to higher coupon payments
Why Premium Bonds Have Lowest Interest Rate Risk:
- Higher coupon payments mean investors receive cash flows sooner
- Earlier cash flows reduce the bond's sensitivity to interest rate changes
- The bond's price is less volatile when interest rates change
Correct Answer: B (Premium bond)
Premium bonds have the lowest interest rate risk because their higher coupon payments result in lower duration compared to discount and zero-coupon bonds of similar maturity.
