Interest Rate Risk and Return: practice question
The managers of a scholarship fund buy newly issued 12-year zero-coupon bonds of Windmere Telecom, intending to sell them in four years rather than hold them to maturity. Regarding the fund's interest rate risk until the sale, which statement is most accurate?
- Because the bonds pay no coupons, nothing must be reinvested along the way, so the position bears no interest rate risk.
- Because the bonds repay their par value at maturity, the proceeds the fund will realize on the sale are fixed in advance.
- The sale proceeds will depend on the yields prevailing in four years, so the fund's realized return is uncertain.
Show answer and explanation
Correct answer: C
Explanation: A zero-coupon bond's locked-in yield is realized only by holding to maturity; a holder selling in four years receives the bond's then-market price, which is set by the yields prevailing at that date, so the fund bears price risk even though it never reinvests a coupon. The no-interest-rate-risk choice conflates reinvestment risk with price risk: having no coupons to reinvest removes the first exposure but leaves the sale price fully exposed to yield changes. The fixed-proceeds choice describes a holder who waits until maturity; this fund sells in Year 4 and never collects the par repayment itself.
More Fixed Income practice Try a mock exam
More free Fixed Income questions
- Peltarine Energy has issued an inverse floating-rate note whose coupon rate each period equals…
- Tarnfield Savings holds a pool of fully amortising residential loans whose borrowers may repay…
- A 6% semiannual-pay bond issued by Corvale Bank pays 3.00 per 100 of par each period and is quoted…
- A bond of Pellworth Communications matures in exactly seven years and yields 6.12%. On-the-run…