Chapter 11, Problem 5Q

To determine

How does the emergence of interest-rate risk help explain financial innovation?

Concept Introduction:

Interest-rate risk is the uncertainty in the interest-rate movements and its returns. Such a risk is applicable to long-term debt instruments. If the holding period of the bond is same as its maturity, usually in case of short-term bonds, there is no interest-rate risk. There has been a vast history in the fluctuations of interest-rate like in the 1970s, where the interest-rate fluctuated from 4% to 11.5% and in the 1980s, where it ranged from 5% to around 15%. Such fluctuations have huge effects on the capital gains and losses. It creates an uncertainty amongst the investors about the future investment returns.