Question

Explain how changes in YTM affects the bond’s market price risk and reinvestment risk

Answer 1

Impact of change in YTM on the bond’s market price risk:
We use yield to maturity (YTM) to discount the future cash flows of a bond (that includes coupon payments and face value amount) to determine its present value. If the YTM increases, then the discounting rate will increase and this will decrease the present value (or market price) of the bond. Similarly, if the YTM decreases, then the discounting rate will decrease and this will increase the market price of the bond.

Impact of change in YTM on reinvestment risk:
YTM determines the total rate of return that a bond holder would earn by holding the bond until maturity. This includes the income from coupon payments and the income from capital gains.
YTM assumes that the coupon payments are reinvested at a rate same as the yield to maturity. It means, a bondholder would actually earn a return that is equal to the yield to maturity when the bond is hold until maturity which is very unlikely (as the yield changes at different point of time) and this rises the reinvestment risk. If the yield decreases, then the coupon payments are reinvested at a lower rate and vice versa.