15. Mr. Bennett wants to invest $100,000 for the next 10 years with the followin

Question

15. Mr. Bennett wants to invest $100,000 for the next 10 years with the following invest- ment strategy. The amount will be invested in a default-free U.S. government security that matures every one month. Every time the security matures, Mr. Bennett will use the proceeds to invest in another government security with one month to maturity. Sup- pose further that one-month government securities today pay an interest rate of 5%. In Mr. Bennett's view, this investment strategy has little risk because one-month securities have no price risk if held to maturity, and he can lock in at least a 5% return over the next 10 years. Discuss this investment strategy and the risks associated with it.

Explanation / Answer

As Bennett invests the amount till maturity of a security , there is no price risk. He will receive the said face value at maturity for a given investment period.

But there is reinvestment risk. 5% is the interest rate today. After few months , if the interest rate decreases, Bennett will have to reinvest the proceeds for a lesser interest rate . So 5% return cannot be locked for the next 10 years. If he wants to lock interest for next 10 years, he ha to invest in zero coupon bond with 10 years maturity . Or by investing in coupon bonds for 10 years can also reduce reinvestment risk ( not completely avoid) that the current strategy . Because in that case only coupons are reinvested. By current startegy, the whole imvestement is reinvested every month.

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