Which of the following bonds exposes an investor to the greatest amount of reinvestment risk in a declining rate environment? a. a mortgage backed security which amortizes monthly. b. a mortgage backed security which amortizes semi-annually c. a non-amortizing bond with monthly coupon payments. d. a zero-coupon bond

a?

A

A

whats everyones reasoning? its definitely not D, as zero-coupon bonds have no coupons for reinvestment… i’d go A over B, since its monthly amortization… but why A over C? is it because we’re in a declining rate environment, thus increasing the chances of prepayment, which leads to higher reinvestment risk???

> but why A over C? a non-amortizing bond. So you`ve only to reinvest the interest.

but isnt reinvestment risk the risk that coupon payments wont be able to be invested at YTM? (whether or not the coupon consists of interest or principal) ?? ie. the risk of reinvesting $10 is the same whether that whole $10 is interest, or whether there is $2 of principal in tehre…

Bluey 1.8T Wrote: ------------------------------------------------------- > but isnt reinvestment risk the risk that coupon > payments wont be able to be invested at YTM? > (whether or not the coupon consists of interest or > principal) ?? > > ie. the risk of reinvesting $10 is the same > whether that whole $10 is interest, or whether > there is $2 of principal in tehre… But the issuer of mortgage can prepay some portion of the debt earlier. Generally for non-amortizing. You have only to reinvest your coupon, but if it is amortizing there is nearly the same interest but more principal.

ahhhh i get what you’re saying… sorry, makes sense now… =) so the fact that its amortising (whether or not we’re in a declining rate environment) that allows for more risk, due to the prepayment option

I was thinking B since in 6 months interest rates will be lower than the average of the last 6 months

I agree Florin, I choose B.

Is it A?

A - principal will be received earlier on the monthly amortizing security

If you were right florin, then extending the amortisation period would increase the reinvestment risk - but this is clearly not true, because if as you extend the amortisation period, you tend towards a coupon bond! So it must be A.

A due to prepayment option of a MBS.

Did I miss the party here? it should be A

I am definitely going with A…

Think about the extreme case: A bond that is amortized every 10 years has a lower reinvestment risk than a bond that amortizes every 2 years (because you don’t have to worry about reinvestment for a whole 10 year period). Consequently, semi-annual amortization has less reinvestment risk than a monthly one. So monthly is more risky - Answer is A and not B. The other two options (C and D) are both extreme cases of amortization where the principal is not repaid until the very end. So you don’t have to worry about reinvestment until maturity. Sure, a non-amortizing coupon bond still pays coupons, but since it does not pay the principal on a monthly basis, the amortizing monthly bond has higher reinvestment risk because it includes both interest and principal payments.