Which of the following types of risk has the most effect on owners of fixed-income securities?

• A. Liquidity risk
• B. Business risk
• C. Interest rate risk
• D. Currency risk

Answer: (C)

Verified step by step guidance

1. Understand the nature of fixed-income securities: Fixed-income securities, such as bonds, provide regular interest payments and return the principal at maturity. Their value is sensitive to changes in interest rates.
2. Define interest rate risk: Interest rate risk refers to the risk that the value of fixed-income securities will decrease due to an increase in market interest rates. This is because the fixed interest payments become less attractive compared to newly issued securities offering higher rates.
3. Compare interest rate risk to other risks: Liquidity risk refers to the difficulty of selling an asset quickly without a significant price reduction. Business risk pertains to the operational and financial risks of the issuing company. Currency risk involves fluctuations in exchange rates affecting the value of foreign investments. These risks are less directly impactful on fixed-income securities compared to interest rate risk.
4. Explain why interest rate risk has the most effect: Fixed-income securities are particularly sensitive to interest rate changes because their cash flows are fixed. When interest rates rise, the present value of these fixed cash flows decreases, leading to a decline in the market value of the securities.
5. Conclude the reasoning: Owners of fixed-income securities are most affected by interest rate risk because it directly impacts the value of their investments, making it the most significant risk compared to liquidity, business, or currency risks.