The Impact of Maturity and Coupon Rate on Interest Rate Risk

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The correct answer is C. The analyst is correct with respect to both the effect of the increase in maturity and the effect of the decrease in the coupon rate on the interest rate risk of a coupon bond.

Interest rate risk refers to the risk that changes in interest rates will affect the value of a bond. When interest rates change, the price of a bond will also change. Coupon bonds, also known as fixed-income securities, pay periodic interest payments (coupon payments) to the bondholders until maturity, at which point the bond's face value is repaid.

Now let's analyze each statement made by the analyst:

1. An increase in the maturity of a coupon bond will increase its interest rate risk: When a bond has a longer maturity, it means that the bondholder will receive coupon payments over a longer period before the bond reaches maturity. Therefore, there is a higher likelihood of changes in interest rates during this longer period, leading to increased interest rate risk. The longer the time until maturity, the more opportunity there is for interest rates to fluctuate, impacting the bond's price. Thus, an increase in maturity increases interest rate risk.

2. A decrease in the coupon rate of a coupon bond will decrease its interest rate risk: The coupon rate represents the annual interest payment expressed as a percentage of the bond's face value. A decrease in the coupon rate means that the bondholder will receive lower periodic coupon payments. When interest rates rise, newly issued bonds will typically offer higher coupon rates to align with market rates. In this scenario, a bond with a lower coupon rate will become less attractive to investors compared to newly issued bonds. Consequently, the bond's price will decrease, increasing its interest rate risk. Therefore, a decrease in the coupon rate decreases interest rate risk.

In summary, an increase in the maturity of a coupon bond increases its interest rate risk because there is more time for interest rates to change. On the other hand, a decrease in the coupon rate of a coupon bond decreases its interest rate risk because lower coupon payments make the bond less attractive when compared to newly issued bonds with higher coupon rates. Hence, the analyst is correct with respect to both the effect of the increase in maturity and the effect of the decrease in the coupon rate on the interest rate risk of a coupon bond.