Silhouette Enterprises must make a balloon loan payment of $1,000,000 in 3 years. The firm’s treasurer wants to purchase a bond that will provide funds for repayment and minimize reinvestment risk. Assume the company has the following four investment options (all with face values of $1,000,000). Market rates are at 8.00 percent. All bonds are noncallable and are otherwise similar except as noted. Which option best meets the treasurer’s requirements? A) A 3-year, zero coupon bond priced to yield 8.00%. B) A 4-year, zero coupon bond priced to yield 8.50%. C) A 3-year, 8.00% semi-annual coupon bond priced at par. D) A 2-year, zero-coupon bond priced to yield 9.00%. **************************************************************** Your answer: D was incorrect. The correct answer was A) A 3-year, zero coupon bond priced to yield 8.00%. Since all the choices are non-callable, the treasurer will prefer a zero-coupon to a coupon bond. While a bond investor can eliminate price risk by holding a bond until maturity, he usually cannot eliminate reinvestment risk. One exception is zero-coupon bonds, since these bonds deliver payments in one lump sum at maturity. Although the 3-year coupon bond fulfills the treasurer’s requirement concerning funds for repayment, it does not minimize reinvestment risk. Among the zero-coupon bonds, the one that best matches the loan’s maturity will minimize reinvestment risk. The treasurer will thus prefer the 3-year, zero-coupon bond. If he purchased the 4-year zero-coupon bond, he would have to sell the bond prior to maturity to payoff the loan and would face price risk. The 2-year zero-coupon bond is attractive because of the higher yield. However, the bond matures one year before the loan is due and would expose the firm to reinvestment risk. ----------------------------------------------- Why isn’t the 2 year 0 coupon bond a better option? I get the par value back at the end of year 2, and i can take the proceeds and, either hold it, or reinvest it at market rate, which will ultimately increase the value > par. It wouldn’t be reinvestment risk because I will be using the proceeds to pay off the loan, so doesn’t matter if the rate goes down or up. Is this correct?
What if market rate in that 3rd year is < 8% …like say 5%. You would be making less money than if you had bought choice A…hence that is why it is called reinvestment risk.
Sine the question wanted to minimize reinvestment risk, zero-coupon has 0 reinvestment risk since it offer no cashflow, given that the company has to make a payment in 3 years, the max. maturity is 3 years. Answer A is the only logic choics given the situation.
Ancient: You need to make a payment in 3 years. So why exactly would a 2-year bond eliminate reinvestment risk?
Yes, i need to make a payment of 1M in 3 years. If i buy a bond that matures in 2 years, I get 1M in year 2. If i have 1M cash in hand and i just let it sit there, the amount will still be 1M by year 3. If the interest rate fluctuates and even drops to 1% and i invest in at that rate, I’d still have gained 1% during year2-3 period. Is this realistic and logical?
that scenario doesn’t make any sense, financially.
I don’t know if you’re understanding correctly ancientmtk. If you have the 3 year bond you’re earning the interest in years 1 - 3. It’s true that with the cash you get at the end of year 2, you can reinvest until you need it at year 3, but you run into reinvestment risk not knowing what rate you’ll get. With the 3 year bond you lock in your rate for all 3 years.
I think I know what ancientmtk is trying to say. the 2 y 0 cupon bond and the 3 y o cupon bond can both do the job since they both mature at par 1mil which is what we neeed to pay but the bottom line is that the 3 y one would be discounted more therefore costing the firm less
Ah thanks flop. I didnt take the PV into account. Now it makes sense that a 2year coupon will have higher reinvestment risk. Thx!