Question

. What is meant by the “reinvestment” assumption? (With regard to the YTM of bonds).

Answer 1

The reinvestment rate is the amount of interest that can be earned when money is taken out of one fixed-income investment and put into another. For example, the reinvestment rate is the amount of interest the investor could earn if he purchased a new bond while holding a callable bond called due because of an interest rate decline.

The reinvestment rate is the amount of interest that can be earned when money is taken out of one fixed-income investment and put into another. For example, the reinvestment rate is the amount of interest the investor could earn if he purchased a new bond while holding a callable bond called due because of an interest rate decline.

Anticipated reinvestment rates play a role in an investor’s decisions about what term to select when purchasing a bond or CD. An investor who expects interest rates to rise might select a shorter-term investment under the assumption the reinvestment rate when the bond or CD matures will be higher than the interest rates that can be locked for longer-maturity investments. When a bond is issued, and interest rates increase, an investor faces interest rate risk. Since bond prices fall when interest rates rise, an investor holding a fixed-rate bond may experience a capital loss if the bond is sold before its maturity date. The longer the time period until maturity, the greater the bond is subject to interest rate risk. Because a bondholder is given the face amount at maturity, bonds nearing the maturity date have little interest rate risk.