You hold a 10-year, zero coupon, bond and a 10-year bond that has a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from the current level, the zero coupon bond will experience the larger percentage decline.

True or False

Answer

TRUE

Explanation

By definition a zero-coupon bond does not make any coupon payments and therefore is sold at a deep discount from the face value. If market rate rises, by definition, the zero-coupon bond would experience a larger percentage decline. The 6% coupon bond would also experience a decline but the coupon payments of the bond would be the reason why this bond would experience smaller percentage decline relatively to the zero coupon bond.

true

Explanation:

In this case, the reinvestment risk favors the bond with the annual coupon, since the proceeds from the coupon can be invested at a higher interest rate. The farther away the proceeds from a bond, the more it will be affected by a change in the market interest rate, that is why it carries a higher interest risk.