Question

Dmitri Ivanov is retiring soon, so he is concerned about his investments providing him steady income every year. He is aware that if interest rates   , the potential earnings power of the cash flow from his investments will increase. In particular, he is concerned that a decline in interest rates might lead to   annual income from his investments.

Dmitri Ivanov is retiring soon, so he is concerned about his investments providing him steady income every year. He is aware that if interest rates   , the potential earnings power of the cash flow from his investments will increase. In particular, he is concerned that a decline in interest rates might lead to   annual income from his investments. a) decrease, increase b) less, more

2. What kind of risk is Dmitri most concerned about protecting against?

Interest rate risk

Reinvestment rate risk

Answer 1

Solution:-

Interest rates in an economy act as the benchmark risk free return based on which the required returns of all risky assets is decided by investors. When interest rates go up, the prices of all financial assets go down to adjust their yields higher with respect to the increased rates and vice-versa.

So, when interest rates go up, Dmriti's investments will be impacted in the following two ways:

• The value of his investment portfolio will go down to adjust its yield higher in accordance with the increase in interest rates. This is known as interest rate risk. As given in the question, Dmitri is not looking to sell his retirement investments, rather he is looking to live on the recurring income generated by them. Thus, the decrease in portfolio's value shouldn't be his concern
• He will be able to reinvest his income from portfolio at higher rates of return that he generates on the portfolio. This will positively impact his retirement planning by increasing the rate of return he can generate from the cash flows of his portfolio.

So, when interest rates go down, Dmriti's investments will be impacted in the following two ways:

• The value of his investment portfolio will go up to adjust its yield downwards in accordance with the decrease in interest rates. As given in the question, Dmitri is not looking to sell his retirement investments, rather he is looking to live on the recurring income generated by them. Thus, the increase in portfolio's value shouldn't be his primary objective
• He will not be able to reinvest his income from portfolio at same rates of return that he generates on the portfolio. This is known as reinvestment risk and will reduce the income he can earn from the cash flows of his investments, thus negatively impact his retirement planning and therefore should be his concern

Based on above explanations, the correct options are as follows:

Answer (1)

(a) increase

(b) less

Answer (2)

Dmriti is most concerned about protecting reinvestment rate risk. This is because as described above, reinvestment risk impact his earnings potential from the cash flows of his portfolio which directly impacts his retirement planning.