Looking for the answer to the question below related to Financial Management ?
If the maturity period of bond is more, investor prefers
|A. Lesser return
B. Higher return
C. Zero return
D. None of these
The Correct Answer Is:
- B. Higher return
The correct answer is B. Higher return. When the maturity period of a bond is longer, investors generally prefer a higher return. Let’s dive into the explanation in more detail.
Bonds are fixed-income securities that are issued by governments, municipalities, and corporations to raise capital. When investors purchase bonds, they are essentially lending money to the issuer in exchange for regular interest payments and the return of the principal amount at maturity.
The maturity period of a bond refers to the length of time until the bond reaches its maturity date, at which point the issuer repays the principal amount to the bondholder. Bonds can have varying maturity periods, ranging from a few months to several decades.
When the maturity period of a bond is longer, it implies that the investor’s money will be tied up for a more extended period. This longer commitment of funds can expose investors to various risks and uncertainties, such as changes in interest rates, inflation, economic conditions, and creditworthiness of the issuer.
Therefore, investors require a higher return to compensate for the additional risks and the opportunity cost of not being able to utilize their funds for other investments.
A longer maturity period increases the risk associated with the bond. Interest rate risk is one of the significant risks that bondholders face. When interest rates rise, the value of existing bonds in the market decreases because investors can get higher returns from newly issued bonds.
This inverse relationship between interest rates and bond prices is known as interest rate risk. Hence, to offset this risk, investors demand a higher return when investing in bonds with longer maturity periods.
Additionally, longer-term bonds are also exposed to higher inflation risk. Inflation erodes the purchasing power of future cash flows, and over an extended period, the impact of inflation can be more significant. Therefore, investors require a higher return on longer-term bonds to compensate for potential inflationary pressures.
Now let’s discuss why the other options are not correct:
A. Lesser return:
It is not correct to say that investors prefer a lesser return when the maturity period of a bond is longer. Investors generally expect to be compensated with a higher return for the additional risks and time commitment associated with longer-term bonds.
C. Zero return:
This option is incorrect because investors would not willingly invest in bonds with a longer maturity period if they expected zero returns. The whole purpose of investing in bonds is to earn income in the form of periodic interest payments.
D. None of these:
This option is incorrect because the correct answer, as discussed above, is B. Higher return. It is essential for investors to consider the risks and time commitment associated with longer maturity bonds and demand a higher return as compensation.
In conclusion, when the maturity period of a bond is longer, investors generally prefer a higher return. The longer commitment of funds exposes investors to various risks, including interest rate risk and inflation risk.
To compensate for these risks and the opportunity cost of tying up their funds for an extended period, investors require a higher return. Therefore, option B, higher return, is the correct answer.