What is the risk of income decline resulting from future drops in interest rates classified as__________?
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Answer: C. Reinvestment risk
Explanation
Reinvestment risk arises when future interest rate drops reduce income from maturing bond coupons. Investors must reinvest incoming periodic cash flows at lower prevailing market interest rates subsequently. This phenomenon particularly impacts holders of short-term bonds and callable fixed-income securities. Fixed-income portfolios face a trade-off between price risk and reinvestment risk over time. Zero-coupon bonds eliminate reinvestment risk because they lack intermediate periodic coupon payments entirely. Long-term bonds generally exhibit high price risk but lower overall short-term reinvestment risk exposure.
Retirees depending on fixed periodic interest payments suffer reduced purchasing power when rates decline. Portfolio managers construct immunized bond portfolios to balance price risk against reinvestment risk carefully. Insurance companies analyze reinvestment risk meticulously to ensure future liability payouts remain fully funded. Income risk is a broad economic term not specifically tied to falling interest rate environments. Investment risk represents general financial uncertainty rather than the specific hazard of lower reinvestment yields. Mature risk is a fabricated industry term that has no recognized meaning in fixed income.
- Subject
- Accounting and Finance
- Category
- Finance
- Topic
- —
- Difficulty
- medium
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