Laura Mack, is considering purchasing two Treasury securities. The first is the 7-year on-the-run Treasury issued last week that has a coupon rate of 4.98%. The second is a 7-year off-the-run Treasury that was issued two months ago and has a coupon rate of 4.74%. Which of the following statements regarding the two issues under consideration is most accurate?
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A. B. C.A
To determine the most accurate statement regarding the two Treasury securities, let's analyze the characteristics of both the on-the-run and off-the-run issues.
Now let's evaluate the given answer choices:
A. The on-the-run issue has higher reinvestment risk because of its higher coupon rate. Reinvestment risk refers to the risk that future cash flows (such as coupon payments) will have to be reinvested at a lower interest rate. In this case, the on-the-run Treasury has a higher coupon rate (4.98%) compared to the off-the-run Treasury (4.74%). Therefore, if interest rates decline, the on-the-run issue's coupon payments will need to be reinvested at a potentially lower rate, resulting in higher reinvestment risk. Hence, statement A is correct.
B. The on-the-run issue has higher interest rate risk because of its higher coupon rate. Interest rate risk refers to the risk of changes in the value of a security due to fluctuations in interest rates. Higher coupon rates tend to make fixed-income securities more sensitive to changes in interest rates. As the on-the-run issue has a higher coupon rate (4.98%) compared to the off-the-run issue (4.74%), it will generally be more affected by changes in interest rates, making statement B correct.
C. Both the on-the-run and the off-the-run issues have equivalent interest rate risk. This statement is incorrect because the interest rate risk is not equivalent for both issues. As explained earlier, the on-the-run issue with the higher coupon rate is more sensitive to changes in interest rates, indicating different levels of interest rate risk compared to the off-the-run issue.
Based on the analysis, the most accurate statement regarding the two issues under consideration is B: The on-the-run issue has higher interest rate risk because of its higher coupon rate.