Question

k. What is interest reinvestment rate risk? Which bond has more interest rate reinvestment rate risk (assuming a 10-year investment horizon)?

g.   What are the key features of a bond?

h.   How do you determine the value of a bond

Answer 1

k.

Bond is a fixed income instrument which is issued by government, corporate bodies and bank etc. to pool the money as loan from its buyer, the investor. Bonds generally pays its buyer pre-defined periodic coupons amount till its maturity except zero coupon bond or deep discount bond.

An interest reinvestment risk always associated with coupon paying bonds or callable bonds. Reinvestment risk refers to a bond holder may not able reinvest periodic coupon payment at the same interest rate of original bond and may have to invest at lower interest rate.

Suppose, A bond issued at par $ 1,000 have coupon rate 10% payable annually and its maturity is 10 years. Now, at the end of first year bond holder get coupon payment of $ 100 and bond holder may have to invest this $ 100 at lower interest rate i.e. less than 10% till maturity, this risk known as interest reinvestment risk.

This risk can be also seen in callable bond. In case of callable bond, the issuer may call the bond before its maturity in case of market interest rate falls to issue new bond at lower interest rate. Now, suppose issuer call the bond then investor get the money before bond maturity and he has to invest at lower interest rate as market interest fall and occurrence of this situation can be called interest reinvestment risk.

Bonds having more interest reinvestment risk –

• Coupon paying Bonds
• Callable bonds

Bonds with no interest reinvestment risk –

• Zero coupon bonds
• Deep discount bonds

As these bonds does not pay any periodic coupons to its holder. However, interest rate risk is always associated with them.

g.

Key features of a Bond

1. Face value

A bond has a Face value which is its basic value and normally its payable to bond holder at maturity of bond.

2. Coupon rate

A bond has coupon rate at which bond holder gets periodic coupon payment from its issuer.

3. Maturity.

Every bond has a maturity, on maturity date bond holder gets bond face value from issuer as a final payment of principal.

4. Yield to Maturity(YTM)

YTM is the rate at which present value of all cash flows becomes equals to Bond value or bond issue price.

5. Issuer

Bonds generally issued by Government , Corporate bodies and Bank etc. to pool the money from market.

h.

Determination of Bond Value –

            Bond value is equals to present value of cash inflows at YTM rate.

$Bond Value = \frac{C_{1}}{(1+YTM)^1} + \frac{C_{2}}{(1+YTM)^2} + .... + \frac{C_{n} + FV}{(1+YTM)^n}$

Where,

C= coupons

YTM = Yield to maturity rate

n = maturity

FV = Face value of bond.

Value of Zero coupon bond -

$Bond Value = \frac{FV}{(1+YTM)^n}$

Where,

YTM = Yield to maturity rate

n = maturity

FV = Face value of bond.