InvestorQ : What is meant by interest rate risk, re-investment risk and default risk with respect to bonds?
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What is meant by interest rate risk, re-investment risk and default risk with respect to bonds?

Answer
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1 year ago


Interest Rate risk

Interest rate risk, market risk or price risk are essentially one and the same. These are typical of any fixed coupon security with a fixed period-to-maturity. This is on account of an inverse relation between price and interest. As interest rates rise, the price of a security will fall. However, this risk can be completely eliminated in case an investor's investment horizon identically matches the term of the security.

Re-investment risk

This risk is again akin to all those securities, which generate intermittent cash flows in the form of periodic coupons. The most prevalent tool deployed to measure returns over a period of time is the yield-to-maturity (YTM) method. The YTM calculation assumes that the cash flows generated during the life of a security is re-invested at the rate of the YTM. The risk here is that the rate at which the interim cash flows are re-invested may fall thereby affecting the returns.

Default risk

This kind of risk in the context of a Government security is always zero. However, these securities suffer from a small variant of default risk i.e., maturity risk. Maturity risk is the risk associated with the likelihood of the government issuing a new security in place of redeeming the existing security. In case of Corporate Securities it is referred to as Credit Risk.