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Amy and Bob are assistant portfolio managers

Finance

Amy and Bob are assistant portfolio managers. The senior portfolio manager has asked them to analyse two option-free bonds with the following characteristics:-

Bond A has a lower coupon than Bond B

Bond A has a shorter maturity than Bond B

Both issues have the same credit rating

Amy and Bob are discussing the interest rate risk of the two issues. Amy says that Bond A has greater interest rate risk than Bond B because of its lower coupon rate. Bob says that Bond B has greater interest rate risk because it has a longer maturity than Bond A.

Suppose you are the senior portfolio manager. How do you suggest that Amy and Bob should decide which bond has the greater interest rate risk and which person is correct with respect to interest rate risk?

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The bond interest rate risk is affected by coupon rate as well as maturity period. Other things keeping equal the bond with lower coupon rate would have higher interest rate risk, similarly other things keeping equal the bond with longer maturity period will have higher interest rate risk. Here when Amy says that Bond A has higher interest rate risk because bond A has lower coupon rate so she might be correctly saying that if we keep the other things constant. Similarly, when Bob says that bond B has greater interest rate risk because its maturity period is higher than Bond A, Bob can also be true if we keep the other things constant. Here the logic applied by both of them is correct but in order to decide which bond has higher interest rate risk we need to calculate the duration of the bond and given the duration is also dependent on the maturity period, there is high probability that Bond B is more interest rate sensitive than bond A, but in order to be sure we should calculate the duration of the bond.