Your best friend Janet is an expert in monetary policy She i

Your best friend Janet is an expert in monetary policy. She informs you that interest rates will increase in the near future even though the bond market is not indicating any sign of this change. Based on Janet\'s information, which one of the following bond\'s is the safest investment? O Long-term; zero coupon. O Long-term; high couporn. O Long-term; low coupon. Short-term; low coupon. Short-term; high coupon.

Solution

Answer - Short term, High coupon

When the interest rate will increase, price of bond will decrease - as interest rate and bond prices have invesrse relationship. This implies increase in interest rate will lead to decline in prices of bond and hence loss for you.

So, we should choose a bond which is least sensitive to interest rates. This means we need to select bond with lowest interest rate risk or lowest duration.

Duration of bonds are influenced by the time to maturity and coupon rate. Higher the time to maturity or lower the coupon, higher would be the duration (or sensitivity of bond price to interest rate). In order to reduce this sensitivity, hence, yous hould invest in a short term bond with high coupon.