Canadian Securities Course (CSC) Level 1 Practice Exam

What is the impact of different coupon rates on bond prices?

1. Higher coupon bonds are less volatile

2. Higher coupon bonds are more volatile

3. Lower coupon bonds are less volatile

4. Lower coupon bonds are more volatile

The correct answer is: Lower coupon bonds are more volatile

The correct understanding of the relationship between coupon rates and bond price volatility reveals that lower coupon bonds tend to be more volatile compared to their higher coupon counterparts. This is primarily because the value of a bond is influenced by its cash flow relative to market interest rates. When a bond has a lower coupon rate, it provides smaller periodic interest payments. As interest rates in the market change, the price of these lower coupon bonds will react more significantly to these fluctuations. This is because investors are less inclined to hold onto a bond that offers lower returns when alternative investments with better yields become available, leading to greater price adjustments. In contrast, higher coupon bonds offer more substantial interest payments, making them less sensitive to changes in market interest rates. The regular income provided by these bonds can cushion investors from fluctuations, resulting in less volatility. Thus, the dynamics of cash flows, market interest rate changes, and investor behavior contribute to the volatility characteristics of bonds with different coupon rates.