University of Central Florida (UCF) FIN4243 Debt and Money Markets Practice Exam 1

The relationship between a bond's maturity and its risk profile is crucial for understanding how interest rate changes can impact the bond's value. A bond with a longer maturity tends to have higher interest rate risk, which refers to the potential for changes in interest rates to lead to fluctuations in the bond's price. This is primarily due to the time value of money and the duration of cash flows.

As interest rates rise, the present value of a bond's future cash flows (interest payments and principal repayment) decreases. Longer maturity bonds have more future cash flows that will be negatively impacted by increasing rates, leading to greater price volatility compared to shorter maturity bonds, which have fewer cash flows remaining. Consequently, when interest rates change, the longer the time until maturity, the more pronounced the impact on the bond's price.

In summary, longer maturity bonds indeed carry higher interest rate risk and more price volatility due to the extended time over which their cash flows will be affected by shifts in interest rates. Thus, the correct interpretation of how a bond's maturity affects its risk profile is accurately encapsulated in the choice given.