Interest Rate Risk

B is correct. When expecting rising interest rates, investors should reduce portfolio duration by moving into shorter-term bonds. Shorter maturities have less price sensitivity to rate changes, minimizing potential losses. This directly addresses Marcus's concern about interest rate risk while maintaining bond exposure.

A is incorrect and counterproductive: longer-term bonds have HIGHER interest rate risk (greater duration), not lower, and would experience larger price declines if rates rise as expected. C is incorrect; zero-coupon bonds have the HIGHEST interest rate risk for any given maturity because duration equals maturity with no coupon cushion. A 10-year zero would decline more than a 10-year coupon bond. D, while partially correct (floating-rate bonds do reduce interest rate risk), may be too extreme for Marcus who wants to minimize losses, not necessarily eliminate all fixed-rate exposure. B provides a balanced approach.

B is correct. Interest rate risk is the risk that a bond's market value will decline when interest rates rise, reflecting the fundamental inverse relationship between bond prices and yields. When rates rise, existing bonds paying lower rates become less valuable because investors can buy new bonds with higher yields.

A describes credit risk (default risk), not interest rate risk. C describes purchasing power risk (inflation risk), which is actually the opposite concern from interest rate risk. D describes liquidity risk, the inability to sell a security quickly without significant price concessions. Interest rate risk specifically refers to price changes driven by changes in market interest rates.

D is correct. The 20-year zero-coupon bond has the highest interest rate risk because (1) it has a long maturity, and (2) zero-coupon bonds have duration equal to their maturity (20 years), making them extremely sensitive to rate changes. With no coupon payments to cushion volatility, the entire return depends on the final maturity value, which is heavily discounted when rates rise.

C (30-year municipal with 3% coupon) has high interest rate risk due to long maturity and low coupon, but its duration would be approximately 17-18 years, still less than the zero-coupon bond's 20-year duration. B (10-year corporate with 5% coupon) has moderate interest rate risk with duration around 7-8 years. A (5-year Treasury with 6% coupon) has the lowest interest rate risk among these options, with duration around 4-4.5 years. The combination of longest effective duration (20 years) and no coupon cushion makes D the highest risk.

C is correct (the EXCEPT answer). Bonds with higher coupon rates have LOWER interest rate risk, not greater risk. Higher coupons return more cash earlier through coupon payments, reducing duration and price sensitivity. This is an inverse relationship: higher coupon = lower interest rate risk.

A is accurate: the inverse relationship between bond prices and interest rates is fundamental. When rates rise, bond prices fall, and vice versa. B is accurate: longer maturity bonds have greater interest rate risk because their cash flows are weighted further into the future, resulting in longer duration and higher price sensitivity. D is accurate: duration is the standard measure of interest rate risk, estimating the percentage price change for each 1% change in yields.

B is correct. Statements 1, 2, and 3 are accurate.

Statement 1 is TRUE: Calculate price change using modified duration: -11 years × 0.50% = -5.5% approximate price decline. This is the primary application of duration for estimating interest rate risk impact.

Statement 2 is TRUE: Interest rate risk is a market value risk, not a credit risk. If the client holds the bond to maturity (assuming no default), they will receive the full par value regardless of interim interest rate movements. This is an important distinction between trading and holding to maturity.

Statement 3 is TRUE: Since rates rose and the bond's market value declined approximately 5.5%, selling now would result in a capital loss compared to the original purchase price (assuming it was bought near par).

Statement 4 is FALSE: Interest rate risk DECREASES as a bond approaches maturity, not increases. As maturity shortens, duration decreases, reducing price sensitivity to rate changes. A 15-year bond has much more interest rate risk than the same bond when it becomes a 5-year bond.