6、An investor holds a 20-year, semi-annual 8.00 percent coupon Treasury bond issued at par. Market interest rates are currently at 6.50 percent. The bond is noncallable. A coupon payment is due this week. Which of the following choices best represents the type of risk the investor faces?

A) Prepayment risk.
 
 
B) Liquidity risk.
 
 
C) Credit risk.
 
 
D) Reinvestment risk.

  The correct answer is D

Reinvestment risk is the risk that if rates fall, cash flows will be reinvested at lower rates, resulting in a holding return lower than that expected at purchase. Here, the investor will likely have to reinvest the coupon at the lower market interest rate, negatively impacting his holding period return.

Prepayment risk (and call risk) is the risk that the issuer will repay principal prior to maturity. Prepayments are most likely in a declining interest rate environment because it is cheaper to issue replacement debt. Here, the bond is a Treasury and is noncallable, so the investor can eliminate prepayment risk by holding the bond until maturity. Liquidity risk addresses how quickly and easily an investor can sell a bond. A bond that trades thinly or in small amounts exposes an investor to liquidity risk. Liquidity risk is not a concern with Treasury bonds. Credit risk is the risk that the issuer will be unable to make coupon or principal payments as scheduled. Any change in the timing of the receipt of cash flows affects the bond’s holding period return. Credit risk is not a concern with Treasury securities.