Baran

AIM 6: Define reinvestment risk.

 

1、When planning to hold a coupon-paying Treasury bond until maturity, which of the following types of risk would be the most important?

A) Reinvestment.
 
 
B) Default.
 
 
C) Downgrade.
 
 
D) Interest rate.
 

Baran

  The correct answer is A

Since it is a Treasury bond, downgrade and default risk are not relevant. Interest rate risk is not important because the investor plans to hold the bond until maturity. Reinvestment risk is the most important. The investor will have to worry about the rates at which he/she will be able to reinvest the coupons over the life of the bond and the principal upon maturity.

Baran

2、Which of the following statements about reinvestment risk is least accurate?

A) A bond's yield calculation assumes that coupon cash flows and principal can be reinvested at the computed yield to maturity.
 
 
B) Reinvestment risk is greater for amortizing securities.
 
 
C) An investor concerned about reinvestment risk is most concerned with a decrease in interest rates.
 
 
D) A bond investor can eliminate reinvestment risk by holding a coupon bond until maturity.
 

Baran

 The correct answer is D

The key word here is coupon bond. While an investor in a fixed-coupon bond can usually eliminate price risk by holding a bond until maturity, the same is not true for reinvestment risk. The receipt of periodic coupons exposes the investor to the risk that he will have to invest the coupons at a lower rate, thus negatively impacting his holding period return. An investor can greatly decrease reinvestment risk by holding a zero-coupon, noncallable bond that is not subject to other prepayments (or embedded options). Zero-coupon bonds deliver all cash flows in one lump sum at maturity.

The other statements about bond yield calculations and reinvestment risks are correct.

Baran

3、Which of the following statements relating to reinvestment risk for bonds is TRUE?

A) Zero coupon bonds have no reinvestment risk over their term.
 
B) Long-term bonds should be purchased if the investor anticipates higher reinvestment rates.
 
C) If the investor anticipates lower reinvestment rates, high coupon bonds should be purchased.
 
D) Unless the reinvestment rate equals the yield to maturity, the holding period return will be less than the yield to maturity.

Baran

 The correct answer is A

 

This statement is true only if the investor holds the bond until maturity. Reinvestment risk means that a bond investor risks having to reinvest bond cash flows (both coupon and principal) at a rate lower than the promised yield. Reinvestment risk increases with longer maturities and higher coupons, and decreases for shorter maturities and lower coupons. While a bond investor can eliminate price risk by holding a bond until maturity, he usually cannot eliminate bond reinvestment risk. One exception is zero-coupon bonds, since these bonds deliver payments in one lump sum at maturity. There are no payments over the life to reinvest.

The statement, "Long-term bonds should be purchased if the investor anticipates higher reinvestment rates," should read, "Short-term bonds...".If an investor expects interest rates to rise, he would want a bond with a shorter maturity so that he received his cash flows sooner and could reinvest at the higher rate. Also, there is less prepayment risk with shorter maturities.

The statement, "If an investor anticipates lower reinvestment rates, high coupon bonds should be purchased," should read, "...low coupon bonds should be purchased...." Again, if an investor expects interest rates to fall, he would want a lower-coupon bond so that he could reinvest the payments and still maintain his expected YTM. 

The statement that begins, "Unless the reinvestment rate...," is partially true. However, the holding period return (covered in a later LOS) could be less or greater than the original yield to maturity (YTM). Over the investor's holding period, interest rates are likely to fluctuate both up and down; at some points the investor will reinvest at a higher rate than the original YTM and sometimes he will reinvest at a lower rate.

Baran

4、The risk that an investor will earn less than the quoted yield-to-maturity on a fixed-coupon bond due to a decrease in interest rates is known as:

A) reinvestment risk.
 
 
B) prepayment risk.
 
 
C) liquidity risk.
 
 
D) event risk.
 

Baran

 The correct answer is A

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.

Prepayment risk (and call risk) is the risk that the issuer will repay principal prior to maturity. Prepayments are most likely to occur in a declining interest rate environment because it is cheaper to issue replacement debt. 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. Event risk means that the issuer could face a single event or circumstance that would affect its ability to service/repay the debt. For example, a corporation could suffer an industrial accident.

Baran

5、Consider four bonds that are similar in all features except those shown. The bond with the greatest reinvestment risk is:

A) 5% coupon, non-callable.
 
B) 15% coupon, callable.
 
C) 15% coupon, non-callable.
 
D) 5% coupon, callable.

Baran

   The correct answer is B

Reinvestment risk is higher with high-coupon, short maturity bonds. Callable bonds have more reinvestment risk than noncallable bonds, since their maturity can be shorter than the stated maturity date.