Interest Rate Risk

The risk that arises for bond owners from fluctuating interest rates is called interest rate risk. How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes. This sensitivity directly depends on two things: the time to maturity and the coupon rate. As we will see momentarily, you should keep the following in mind when looking at a bond:

1. All other things being equal, the longer the time to maturity, the greater the interest rate risk.

2. All other things being equal, the lower the coupon rate, the greater the interest rate risk.

We illustrate the first of these two points in Figure 7.2. As shown, we compute and plot prices under different interest rate scenarios for 10 percent coupon bonds with maturities of 1 year and 30 years. Notice how the slope of the line connecting the prices is much steeper for the 30-year maturity than it is for the 1-year maturity. This steepness

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