Which of the following bonds would have the most re-investment rate risk? a. A 20-year, 10% coupon bond. b. A 20-year zero coupon bond. c. A 10-year, 10% coupon bond. d. A 10-year, zero coupon bond.

Question

Yuliana Vincent

Business

31 July, 11:47

Which of the following bonds would have the most re-investment rate risk? a. A 20-year, 10% coupon bond. b. A 20-year zero coupon bond. c. A 10-year, 10% coupon bond. d. A 10-year, zero coupon bond.

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Answers (1)

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Mylie Bradshaw · Answer 1

a. A 20 year, 10% coupon bond

Explanation:

Reinvestment risk refers to the risk of earning lower rate of return than the return earned on current investments.

For example, a $1000, 6% callable bond is issued. The lender earns 6% i. e $60 per annum. Suppose the market interest rates drop to 4% and the issuer redeems these bonds. Then, the lender has to invest his proceeds at 4% and not unlike 6% in previous case.

This means, his rate of return has reduced on reinvestment. This is reinvestment risk.

Bond term is directly related to reinvestment risk. Higher the term, higher the reinvestment risk.

In the given case, 20 year 10% coupon bond bears the most reinvestment risk since the term is more. Higher the term of the bond, higher the possibility that interest rates would be lower than the interest rate at the time of purchase.