Which of the following statements are true?

A multinational bank just bought two bonds each worth $10,000. One of the bonds pays a fixed interest of 5% semi-annually and the other pays LIBOR semi-annually. The six month LIBOR is at 5% currently. The risk manager of the bank is concerned about the sensitivity to interest rates.

Which of the following statements are true?
A . The price of the bond paying floating interest is more sensitive to interest rates than the bond paying fixed interest.
B . The price of the bond paying fixed interest is more sensitive to interest rates than the bond paying floating interest.
C . Both bond prices are equally sensitive to interest rates.
D . The given information is not enough to determine the sensitivity of the bond prices.

View Answer

Answer: B

Explanation:

A bond that pays fixed interest is more sensitive to changes in interest rates than a bond that pays floating interest. This is because the fixed interest bond’s coupon payments are constant, and its price will fluctuate more as interest rates change. In contrast, the floating interest bond adjusts its coupon payments according to the current interest rates, making its price less sensitive to changes in the market interest rates.