Question

Describe the concepts of interest rate risk and reinvestment risk. Given these concepts of risk, what does this say about risk-free bonds?

Answer 1

INTERESTIRARA RISK : interest rates don't stay static they move up and down.,interest rate risk refers to the impact that rising interest rates have on bond values. When the interest rates go up, the value of an existing bond comes down. And when interest rate fall the value of bond goes up.

REINVESTMENT RISK: An investment gives return in the course of it's life. Example fixed deposits pay interest, stock pays dividends. In arriving at the return from these investments we assume that the intervening cash flows are reinvented at the same rate.if they cannot be reinvested at the same rate but have to be reinvested at lower rates then the investment is said to suffer reinvestment rate risk.

Risk free bonds are the bonds which are having proper repayment of principal amount and timely interest payments without any uncertainties (risk). In general there is small portion of risk whether these bonds are issued by central banks because the concept of interest rates are highly influenced by central banks only the ups and downs in interest rates influences the risk free bonds also but the amount of influence is very less portion.