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FRM Part II · FRM Exam Part II · The Investment Function in Financial Services Management

A bank treasurer holds a 5-year Treasury note purchased at par with a 4% coupon as part of the bank's investment portfolio. Market yields then rise by 100 basis points. Which statement best describes the effect on the note?

The note's market price falls, leaving an unrealized loss versus cost. A fixed-coupon bond's cash flows are discounted at a higher yield after rates rise. Being default-free removes credit risk but not interest rate risk, and the fixed coupon does not adjust.

  1. AIts market price falls, so the bank holds an unrealized loss relative to costCorrect
  2. BIts market price rises because the coupon is now above the yield curve average
  3. CIts price is unchanged because Treasury securities carry no credit risk
  4. DIts coupon income rises automatically to match the new market yield

Explanation

Fixed-coupon securities lose market value when yields rise, because future cash flows are discounted at a higher rate. Absence of credit risk does not remove interest rate risk. The coupon is fixed, so it does not reset.

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