47. Which of the following statements is true of interest rate risk?
Answer: D
Long-term maturities, low coupon rate bonds and deep discount bonds are most susceptible to this type of risk.
Interest rate risk is primarily associated with the sensitivity of bond prices to changes in interest rates, and it is most pronounced in long-term maturities, low coupon rate bonds, and deep discount bonds due to their longer duration and lower cash flows.
A) Lower interest rates will cause bond prices to fall.
This statement is incorrect. In fact, lower interest rates typically lead to higher bond prices, as existing bonds with higher interest rates become more valuable in comparison to newly issued bonds with lower rates.
B) Rising interest rates will cause bond prices to rise.
This statement is also incorrect. Rising interest rates generally lead to falling bond prices, as newer bonds are issued at higher rates, making existing bonds with lower rates less attractive.
C) Short-term maturities, high coupon rate bonds and premium bonds are most susceptible to this type of risk.
This statement is misleading. Short-term maturities and high coupon rate bonds are typically less susceptible to interest rate risk because they have less time for rates to affect their prices significantly. In contrast, long-term and low-coupon bonds are more sensitive to interest rate fluctuations.
D) Long-term maturities, low coupon rate bonds and deep discount bonds are most susceptible to this type of risk.
This statement is correct. Long-term bonds, especially those with low coupon rates and deep discounts, experience greater price volatility in response to interest rate changes because their cash flows are further in the future, making them more sensitive to the present value calculations affected by interest rate shifts.
Conclusion
The correct answer is definitively D, as it accurately reflects the nature of interest rate risk, where long-term, low coupon, and deep discount bonds are significantly impacted by changes in interest rates. Options A, B, and C misrepresent the relationship between bond prices and interest rates, failing to capture the true dynamics of interest rate risk in the bond market.