Question: Tim Owens is currently managing his portfolio against a liability structure. However, interest rates have recently declined and some of the bonds in his portfolio have been called. Owens is faced with having to reinvest the principal of those bonds at lower rates of return. Identify the risk(s) that Owens is facing while managing his portfolio. Answer: Call risk, interest rate risk (reinvestment), and cap risk. Call and reinvestment rate risk sure…but why cap risk???
since the bonds are floating rate, they may be subject to a maximum increase in rates (cap risk). It doesn’t say anything about it in the quesiton, by the look of it, but in theory floating rate bonds could be subject to cap risk unless otherwise stated. I know that’s not to helpful, but its the best i could come up with.
Yeah, you are thinking along the same lines I was, but as you said, there’s no mention of it in the question. Call risk and interest rate risk are obvious. But to just throw cap risk in there with no mention of any situation in the question to point you there, aren’t there a bunch of other risks you could just randomly throw in there as well.
Welcome to my frustration. You will experience this kind of situation in more places.