Question

(1) Price (interest rate) risk is the risk of a decline in bond values due to increase in interest rates. Why do investors of long maturity bonds undertake higher price risk than investors of short maturity bonds? Reinvestment risk is the risk of an income decline due to decrease in interest rates. Why do investors of short maturity bonds undertake greater reinvestment risk than investors of long maturity bonds?

(2) On October 16, 2013, Congress passed a bill to reopen the government through January 15, 2014 and raise debt ceiling until February 7, 2014 to avert default of the government and avoid a downgrade of the government credit rating. Why is it important to avoid the downgrade of credit rating? Explain.

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1. Bonds have different maturities and as the maturity of the bond increases, there is an increase in the maturity risk premium associated with the bond. Long term bonds offer higher returns to the investors so that they are comfortable in investing their funds in one security for a long time. Longer time period leads to higher levels of uncertainty as it is not possible...

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