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Difficulty: EasyDebt Securities and Bond Structure

An investor holds a 1010-year U.S. Treasury bond. Although U.S. Treasury debt obligations are backed by the full faith and credit of the U.S. government and carry virtually no credit (default) risk, the investor notices that the bond's market price declines whenever overall market interest rates increase. Which of the following risks is directly responsible for this price fluctuation?

  1. Interest rate riskAnswer
  2. B
    Default risk
  3. C
    Inverted yield curve risk
  4. D
    Municipal tax exemption risk

Answer

Interest rate risk
Interest rate risk describes the potential for a fixed-income security's market price to decline when prevailing market interest rates rise. Even though U.S. Treasury securities carry virtually zero default (credit) risk, all fixed-rate debt securities remain subject to interest rate risk prior to maturity.

Step-by-Step Solution

1
Identify the risk characteristics of U.S. Treasury debt securities described in the scenario.
The bond is free of default risk because it is backed by the U.S. government.
U.S. Treasury securities have virtually zero credit risk.
2
Analyze the relationship between rising prevailing interest rates and existing fixed-rate bond prices.
When market interest rates rise, existing fixed-rate bond prices fall to remain competitive.
Bond prices and market yields share an inverse relationship.
3
Select the financial term that defines market price fluctuations driven by interest rate movements.
Interest rate risk
Interest rate risk specifically measures the sensitivity of a bond's market value to interest rate changes.

Key Concept

Interest Rate Risk vs. Default Risk in Debt Securities
Estimated Time:45s
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Topics

Debt Securities and Bond Structure

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