\"Reinvestment rate risk\" is of importance to bond purchasers because ____. the
ID: 2813389 • Letter: #
Question
"Reinvestment rate risk" is of importance to bond purchasers because ____.
the value of their bonds can increase
the interest proceeds from the current bond may be reinvested at a lower interest rate than that of the current bond.
Both of the above are true.
Neither of the above are true.
the value of their bonds can increase
the interest proceeds from the current bond may be reinvested at a lower interest rate than that of the current bond.
Both of the above are true.
Neither of the above are true.
Explanation / Answer
Correct answer is (B) the interest proceeds from the current bond may be reinvested at a lower interest rate than that of the current bond.
The risk of reinvestment is the risk that future cash flows, coupon payment or return of principal amount, are reinvested in lower-yielding securities.
For example, if a bond of face value $1000 matures after 5 years with coupon rate of 5% annually.
$50 will be received by investor annually as interest payment.
If prevailing coupon rate of the similar type of bond falls to 3% then, investor will receive only $30 for similar bond. So, the investor might need to reinvest the interest income on new bond at lower rates. If interest rates afterwards rise, then the bond paying 3% falls in value. If investor needs to take out cash early (selling bond before maturity) then investor may lose portion of principal as well.
So, option A) value of bond can increase is not risk. A fall in value of bond is risk to the investor.
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