Question

Why is “interest rate price risk” and “reinvestment risk” important?

Explain, then, what happens to those when a) we switch from short to long term bonds, and b) bonds with low to high coupons?

Answer 1

Interest rate price risk is important because it relates to change in the interest rate and its is highly important as it compares the bond yield to prevalent market rate of interest.

interest rate price risk is very high for those bonds who have lower coupon rates because they will have a higher fluctuation in nature.

Reinvestment risk means risk of getting and investment cancelled because the Issuer has either called off the bonds or cancel the bonds and the investor will have to find a new place for reinvestment of his capital.

Both type of interest rate risk and reinvestment risk are important because it will lead to a very high rate of change in overall return related to a particular security and they are both dependent upon change in the prevalent events.

when we switch from short term bonds to long term bonds the interest rate risk as well as the reinvestment risk will always be higher because the interest rate risk is higher for long duration bonds because of their higher maturity.

Interest rate risk and reinvestment risk is higher for low coupon bonds because they are very sensitive to any rate change as it is seen as a alternative form of investment.