Do the interest rate and the bond price move in the same or opposite...
Do the interest rate and the bond price move in the
same or opposite direction? If you are a bond investor and
you expect that the Federal Reserve will cut the interest rate in 3
months, what action you are going to take now? Why?
Discuss the difference between the interest rate risk
(price risk) and the reinvestment rate risk (reinvestment risk) in
terms of time to maturity.
Homework Answers
Ans 1. Interest rate and bond price move in opposite direction. When interest rate rises bond price decreases.
Ans 2. When interest rates are to be slashed in near future it is advisable to purchase bonds now so that bond's price goes up when the interest rates are slashed. Investor can earn profit by selling the bond when interest rates are slashed by Federal Reserve because the price of the bond will appreciate.
Ans 3. Interest rate risk is the adverse movement of interest rate that reduces the value of your investment in the bond. your investment is subject to this type of risk if you do not want to keep your money invested in the bond till its maturity. Suppose the maturity of the bond is five years hence and you want to sell the bond now because you are in need of money. If interest rate is greater than the coupon of the bond then the price you will be getting for your bond will be lesser than your investment in the bond. i.e. in this case your investment is exposed to interest rate risk.
Reinvestment risk is the risk generally associated with callable bonds. Callable bonds are those which the issue can call for redemption even before the maturity of the bond. Suppose you want to keep your investment in the bond for now as the coupon being paid by the bond is greater than the interest rate in the market. Now if the issuer calls the bond for redemption you will get your investment in the bond back but due to lesser prevailing market interest rate you won't find any other instrument which would give you similar return same as the bond you had invested in. That means your investment in the callable bond is subject to reinvestment risk.
Add Answer to:
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