Question

explain the difference btween price risk and reinvestment risk

Answer 1

As a bond investor investors face two types of risk namely price and reinvestment risk. These two are inversely related means if one is increased other is decreased and vice versa.

Price risk also known as interest rate risk is the decrease in the bond prices caused by a rise in interest rates and vice versa.

It tells how much the value of the portfolio fluctuates. The longer the duration of a bond the greater its price volatility. In other words a change in interest rates has a greater effect on the price of a longer duration bond than the shorter one.

Other factors that affect interest rate risks are

·         Maturity - Longer maturity increases interest rate risk (higher duration = more sensitive to changes in interest rates)

·         Coupon rate – An increase in coupon rate will decrease interest rate risk (more value of bond is in shorter term coupon payments)

·         YTM – An increase (decrease) in a bond’s YTM will decrease (increase) interest rate risk (think about the slope of the yield curve as yields change)

·         Embedded options – Both put/call provisions decrease a bond’s interest rate risk as they reduce effective duration

Reinvestment risk

Every bond pays coupon at the end of half year or year and pays principal amount at the end of maturity period.

For example a 10% $1000 bond of 8 year maturity will pay a coupon payment of $100 per year and at the end of 8 years pays principal amount of 1000 as well.

Now suppose first year interest rate is 10% now in future years interest rate falls to 8% per year resulting in increase in bond price as when interest rate falls bond price increases therefore interest rate falls to 8% increase the bond price to 1050 so some investors will sell and make profit others or in fact most do not track bond prices daily so they will continue to hold till maturity and will earn 8% interest or coupon payment resulting in a reinvestment risk means their 100 first year interest is reinvested at lower interest rate of 8% so interest on interest risk also known as reinvestment risk is present in bonds.

For equity investors there is only risk called price risk meaning there is a risk of falling in equity prices due to increase in interest rates. When market interest rates are increasing naturally investors like to invest more in bond markets as they are safer than share investments.

Also increase in interest rates will make loans expensive means less people would borrow when lesser people would borrow then banks profits would go down, auto sales like car sales would be lesser as many people buy cars on loans when loans are expensive they would avoid buying new cars similarly with home loans so all industries would perform badly resulting in decrease in share price resulting in price Risk which affects investors portfolio.