If bonds are identical except for the coupon rate, the one with the lowest coupon will exhibit the most price volatility. This is because a bond’s price is determined by discounting the cash flows. A lower-coupon bond pays more of its cash flows later (more of the cash flow is comprised of principal at maturity) than a higher-coupon bond does. Longer-term cash flows are discounted more heavily in the present value calculation. Another way to think about this: The relationship between the coupon rate and price volatility (all else equal) is inverse – a greater coupon results in less price volatility. Examination tip: If you get confused on the examination, remember that a zero-coupon bond has the highest interest rate risk because it delivers all its cash flows at maturity. Since a zero-coupon bond has a 0.00% coupon, a low coupon equates to high price volatility. |
