Question

A customer has purchased three different bonds, each yielding 9%, with 5 year, 10 year, and 15 year maturities. If prevailing interest rates drop by 20 basis points, which will show the greatest percentage price change?

Answer 1

Answer:

The bond with 15 year maturity.

Explanation:

The reason is that rate of percentage change in price of an investment with long term maturity will be faster than the rate of percentage change in price of an investment with a short term maturity as the interest rate changes.

This is because the longer the length of maturity, the greater is compounding effect. Therefore, when the interest rate drops, the price of the long term maturity will rise faster than the price of the short term maturity.

In this question's case, a 20 basis points drops in the interest rates will make the price of the bond with 15 year maturity to witness the greatest percentage change or rise in price.

I wish you the best.