Question

Reinvestment risk is the greatest for which one of the following bonds

8.00% coupon rate and 20 years to maturity

4.00% coupon rate and 20 years to maturity

4.00% coupon rate and 10 years to maturity

8.00% coupon rate and 10 years to maturity

I was thinking this was 4 and 20 but am not sure! Thank you!

Answer 1

Reinvestment risk is the risk that the investor will not be able to invest the cash flow earned at the same return which he earns on the investment i.e the returns earned on the cash flows invested will be less than the return on the original investment. When the interest rate falls the subsequent cash flows will be invested at lower rate.

The longer maturity investments have less reinvestment risk as the principle amount  will not be available soon and they will not be re invested soon,

and the lower coupon rate investments has lower reinvestment risk.

The reinvestment risk will be maximum for larger coupon rates investments as the investor may not get the same rate of return on the cash flows and short maturity bonds as there will be need to reinvest them soon and there will be risk that the interest rate will fall and the investment will provide lower return.

Hence,

Reinvestment risk is the greatest for 8.00% coupon rate and 10 years to maturity.

Hope it helps!