a. If you, as an investor, has a long-term investment horizon, explain your level of price risk and

reinvestment risk if you are holding:

a. Short-term bonds

b. Long-term bonds

c. High coupon bonds

Price Risk

Interest rates fluctuate over time, and when they rise, the value of outstanding bonds decline. This risk

of a decline in bond values due to an increase in interest rates is called price risk (or interest rate

risk).

Price risk is higher on bonds that have long maturities than on bonds that will mature in the near future.

Since interest rates can and do rise, rising rates cause losses to bondholders; people or firms who

invest in bonds are exposed to risk from increasing interest rates.

Reinvestment Risk

The risk that a decline in interest rates will lead to a decline in income from a bond portfolio refers to

reinvestment risk. It is the risk of an income decline due to a drop in interest rates.

We noted that an increase in interest rates hurts bondholders because it leads to a decline in the

current value of a bond portfolio. But can a decrease in interest rates also hurt bondholders? The

answer is yes because if interest rates fall, long-term investors will suffer a reduction in income.

For example, consider a retiree who has a bond portfolio and lives off the income it produces. The

bonds in the portfolio, on average, have coupon rates of 10%. Now suppose interest rates decline to

5%. Suppose many of the bonds will mature or be called; as this occurs, the bondholder will have to

replace 10% bonds with 5% bonds. Thus, the retiree will suffer a reduction of income.

Reinvestment risk is obviously high on callable bonds.

It is also high on short-term bonds because the shorter the bond's maturity, the fewer the years before

the relatively high old coupon bonds will be replaced with the new low-coupon issues. Thus, retirees

whose primary holdings are short-term bonds or other debt securities will be hurt badly by a decline in

rates, but holders of non-callable long-term bonds will continue to enjoy the old high rates.

Comparing Price Risk and Reinvestment Risk

Note that price risk relates to the current market value of the bond portfolio, while reinvestment risk

relates to the income the portfolio produces. If you hold long-term bonds, you will face significant price

risk because the value of your portfolio will decline if interest rates rise, but you will not face much

reinvestment risk because your income will be stable.

On the other hand, if you hold short-term bonds, you will not be exposed to much price risk, but you

will be exposed to significant reinvestment risk.

To summarize, please refer to the table below:

There is this term that is called investment horizon. It is the period of time an investor plans to hold

a particular investment.

Which type of risk is "more relevant" to a given investor depends on how long the investor plans to

hold the bondsthis is often referred to as his or her investment horizon. To illustrate, consider an

investor who has a relatively short 1-year investment horizonsay, the investor plans to go to

graduate school a year from now and needs money for tuition and expenses. Reinvestment risk is of

minimal concern to this investor because there is little time to reinvest. The investor could eliminate

price risk by buying a 1-year Treasury security because he would be assured of receiving the face

value of the bond 1 year from now (the investment horizon). However, if this investor were to buy a

long-term Treasury security, he would bear a considerable amount of price risk because, as we have

seen, long-term bond prices decline when interest rates rise. Consequently, investors with shorter

investment horizons should view long-term bonds as being more risky than short-term bonds.

By contrast, the reinvestment risk inherent in short-term bonds is especially relevant to investors with

longer investment horizons. Consider a retiree who is living on income from her portfolio. If this investor

buys 1-year bonds, she will have to "roll them over" every year, and if rates fall, her income in

subsequent years will likewise decline. A younger couple saving for their retirement or their children's

college costs, for example, would be affected similarly because if they buy short-term bonds, they too

will have to roll over their portfolio at possibly much lower rates. Because of the uncertainty today

about the rates that will be earned on these reinvested cash flows, long-term investors should be

especially concerned about the reinvestment risk inherent in short-term bonds.