a fixed income manager wants to take advantage of a forecast decline in interest rates over the next several months. Which of the following combinations of matureity and coupon rate MOST likely result in the largest increase in portfolio value? a. Maturity 2015, coupon rate 10% b. Maturity 2015, coupon rate 12% c. Maturity 2030, coupon rate 10% d. Maturity 2030, coupon rate 12% shouldn’t the answer be the Shortest maturity with the Highest Rate?
Correct answer is C
Would also say C. Duration/interest rate risk would be greatest for bonds with longer maturities and lower coupons and this the value of the portfolio would increase.
so in this case we’re looking for higher risk which means higher return?? isn’t shorter maturity more liquid, the better?
This is a question about how much a bond’s current price changes based on a change in the market rate. Because long maturity bonds with most of their current value coming further in the future (lower coupons) respond the most drastically to interest rate changes, this is the type of bond that someone predicting a decrease in interest rates should buy.
Duration can be understood as the percent change in price due to a change in rates. The question states that there is going to be a decline in interest rates…thus what would be the best portfolio to choose from…the one that would have the highest duration or interest rate risk. Duration is greatest for bonds that have: longer maturities, lower coupons, lower initial yields. Based on that definition, and those guidelines…C would have the greatest increase in value.
C…>>>>>longer maturity plus lower coupon (if possible zero coupon) because you expect price decline. You know bond price will go up. In this case, you want bonds with the maximum interest rate sensitivity so that you will enjoy the largest price changes (capital gain) from the change in the interest rate. You will act in reverse (shorter maturity + higher coupon) if it was a forecast interest increase. This combination will give you minimal price volatility for change in the interest rate. Thanks.
C maturity + lower coupon (think Z-bond)
Could anyone help me: why longer maturity results in more interest rate risk?? why low coupon rate have the same response too?? how to understand the relationship between interest rate and coupon rate?? And what’s the relationship between YTM and interest rate?? Crazy ~~~~
why longer maturity results in more interest rate risk?? Longer time for interest rates to change, if you take a 10year bond at 2%, the rate in 20years might be 50% in which case you’ve totally screwed up. More time more risk. why low coupon rate have the same response too?? Higher coupon generally means higher yield, so the interest rate would have to go that much more higher for you to be essentially losing money. Interest rate is a generalisation of current bond yields. If interest rates (rates not rate) go up then bond yields are effectively going up.