Does an investor who purchases a zero-coupon bond face reinvestment risk?
What will be an ideal response?
For zero-coupon bonds, unlike bonds that pay a stream of coupon payments over time, the payment is reinvested at the same rate as the coupon rate. This eliminates any risk associated with the possibility that coupon payments will be reinvested at a lower rate. However, if rates go up, then the zero coupon bond will fall in value because its "locked-in" rate is below the higher market rate. In contrast to zero-coupon bond, the calculation of the yield of a coupon paying bond assumes that the cash flows received are reinvested at the prevailing rate when the coupon payment is received. Because this rate is not known in advance it creates uncertainty and so it is called by the name of reinvestment risk to indicate there is risk or uncertainty in the reinvesting of coupon payments.
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