Which one of the following is the most important source of risk from owning bonds?

• A. Operational risk
• B. Inflation risk
• C. Interest rate risk
• D. Liquidity risk

Answer: (C)

Verified step by step guidance

1. Step 1: Understand the concept of risk in bond ownership. Bonds are debt instruments that pay fixed interest over time, so their value and returns can be affected by various types of risks.
2. Step 2: Define each type of risk briefly: Operational risk relates to failures in internal processes or systems; Inflation risk is the risk that inflation will erode the purchasing power of the bond's fixed payments; Interest rate risk is the risk that changes in market interest rates will affect the bond's price; Liquidity risk is the risk that the bond cannot be easily sold without a price concession.
3. Step 3: Recognize that the most important risk for bondholders is typically interest rate risk because bond prices move inversely with interest rates. When interest rates rise, existing bond prices fall, affecting the bondholder's potential capital gains or losses.
4. Step 4: Understand why inflation risk, while important, is secondary to interest rate risk in terms of immediate impact on bond prices. Inflation risk affects the real value of payments but does not directly change the bond's market price as quickly as interest rate changes do.
5. Step 5: Conclude that among the options, interest rate risk is the most important source of risk from owning bonds because it directly influences the bond's market value and the investor's return if the bond is sold before maturity.