Examples of Reinvestment risk in the following topics:
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- Reinvestment risk is the risk that a bond is repaid early, and an investor has to find a new place to invest with the risk of lower returns.
- Reinvestment risk is one of the main genres of financial risk.
- Reinvestment risk is more likely when interest rates are declining.
- Pension funds are also subject to reinvestment risk.
- Two factors that have a bearing on the degree of reinvestment risk are:
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- Price risk is positively correlated to changes in interest rates, while reinvestment risk is inversely correlated.
- So there is little reinvestment risk.
- There is, accordingly, more reinvestment risk.
- Reinvestment risk and interest rates are inversely correlated.
- In summary, price risk and reinvestment risk are two main financial risks resulting from changes in interest rates.
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- Bonds are subject to risks such as the interest rate risk, prepayment risk, credit risk, reinvestment risk, and liquidity risk.
- Bonds are also subject to various other risks such as call and prepayment risk, credit risk, reinvestment risk, liquidity risk, event risk, exchange rate risk, volatility risk, inflation risk, sovereign risk, and yield curve risk.
- If there is any chance a holder of individual bonds may need to sell his bonds and "cash out", the interest rate risk could become a real problem.
- As with interest rate risk, this risk does not affect the bond's interest payments (provided the issuer does not actually default), but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.
- This creates reinvestment risk, meaning the investor is forced to find a new place for his money.
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- The expectation hypothesis of the term structure of interest rates is the proposition that the long-term rate is determined by the market's expectation for the short-term rate plus a constant risk premium.
- Shortcomings of the expectations theory is that it neglects the risks inherent in investing in bonds, namely interest rate risk and reinvestment rate risk.
- This premium compensates investors for the added risk of having their money tied up for a longer period, including the greater price uncertainty.
- Long-term yields are also higher not just because of the liquidity premium, but also because of the risk premium added by the risk of default from holding a security over the long-term.
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- The expectation hypothesis of the term structure of interest rates is the proposition that the long-term rate is determined by the market's expectation for the short-term rate plus a constant risk premium.
- Shortcomings of expectations theory is that it neglects the risks inherent in investing in bonds, namely interest rate risk and reinvestment rate risk.
- This premium compensates investors for the added risk of having their money tied up for a longer period, including the greater price uncertainty.
- Long term yields are also higher not just because of the liquidity premium, but also because of the risk premium added by the risk of default from holding a security over the long term.
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- NPV and PI assume reinvestment at the discount rate, while IRR assumes reinvestment at the internal rate of return.
- A firm's weighted average cost of capital (after tax) is often used, but many people believe that it is appropriate to use higher discount rates to adjust for risk or other factors.
- Related to this concept is to use the firm's reinvestment rate.
- Reinvestment rate can be defined as the rate of return for the firm's investments on average.
- IRR assumes reinvestment of interim cash flows in projects with equal rates of return (the reinvestment can be the same project or a different project).
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- Dividend reinvestment plans (DRIPs) automatically reinvest cash dividends in the stock.
- This is called a dividend reinvestment program or dividend reinvestment plan (DRIP).
- The purpose of the DRIP is to allow the shareholder to immediately reinvest his or her dividends in the company.
- Participating in a DRIP, however, does not mean that the reinvestment of the dividends is free for the shareholder.
- Thus, participating in a DRIP helps shareholders avoid some or all of the fees they would occur if they reinvested the dividends themselves.
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- Since many people believe that it is appropriate to use higher discount rates to adjust for risk or other factors, they may choose to use a variable discount rate.
- Related to this concept is to use the firm's reinvestment rate.
- Reinvestment rate can be defined as the rate of return for the firm's investments on average, which can also be used as the discount rate.
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- Firstly, IRR assumes that interim positive cash flows are reinvested at the same rate of return as that of the project that generated them.
- This is usually an unrealistic scenario and a more likely situation is that the funds will be reinvested at a rate closer to the firm's cost of capital.
- Generally, for comparing projects more fairly, the weighted average cost of capital should be used for reinvesting the interim cash flows.
- To calculate the MIRR, we will assume a finance rate of 10% and a reinvestment rate of 12%.
- Second, we calculate the future value of the positive cash flows (reinvested at the reinvestment rate): FV (positive cash flows, reinvestment rate) = 5000*(1+12%) +2000 = 7600.
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- The financial intermediary then reinvests the money against a higher rate of interest.
- Funding an international business has to take into consideration the political risk of the country that the company is going to operate in.
- Political risk can result in a severe financial loss for a firm.
- However, it is rarely the optimal structure since a company's risk generally increases as debt increases.