Which of the following statements is true?
a. The interest rate risk premium always adds a downward bias to the slope of the yield curve.
b. If investors believe inflation will be subsiding in the future, the prevailing yield will be upward sloping.
c. The real rate of interest varies with the business cycle, with the lowest rates seen at the end of a period of business expansion and the highest at the bottom of a recession.
d. The longer the maturity of a security, the greater its interest rate risk.
Interest Rate Risk:
Interest rate risk measures how sensitive the price of an asset is with respect to changes in interest rate. The interest rate risk of a bond could be measured by the bond's duration. The longer the duration, the higher the interest rate risk.
Answer and Explanation:
The answer is d.
The longer the maturity of a security, the more distant from present date are future cash flows. In this case, the present value of a given future cash flow will decline (increase) more when interest rate increases (declines) by a given percentage. Hence, the value of the security will also change by a larger percentage as a result of interest rate change, i.e., the greater the interest rate risk is.
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fromChapter 3 / Lesson 6
Interest rate risk is really the risk of two different events (price reduction and reinvestment rate reduction) caused by a change in interest rates. Interest rate risk affects bond investments, but the good news for bond investors is that it can be mitigated or eliminated.