Chartered Institute of Stockbrokers (CISI) Professional Practice Exam

What impact does the market risk have on bond investments?

1. Increases the bond's maturity duration

2. Alters the company's credit worthiness

3. Results from fluctuations in interest rates

4. Affects the bond's dividend yield

The correct answer is: Results from fluctuations in interest rates

Market risk, often referred to as systematic risk, directly relates to the broader economic environment and can significantly impact bond investments. The correct answer highlights that market risk results from fluctuations in interest rates. When interest rates change, the prices of existing bonds often move inversely to these changes. If interest rates rise, the market value of existing bonds falls because new bonds are likely to be issued at higher rates, making the lower-rate bonds less attractive to investors. Conversely, if interest rates decline, existing bonds with higher rates become more valuable. This relationship underscores the inherent market risk associated with bond investments, as fluctuations in interest rates can lead to significant changes in bond prices, impacting an investor's return. The other options, while related to bonds, do not accurately define the direct impact of market risk. For instance, bond maturity duration is influenced by various factors, but market risk is more about price fluctuations due to interest rate changes rather than duration itself. The company's creditworthiness pertains to default risk rather than market risk. Lastly, dividends are not a characteristic of bonds; bonds provide coupon payments, but dividend yield is specific to equity investments. Thus, understanding that market risk revolves around interest rate fluctuations is crucial for effectively managing bond investments.