CFA Practice Question

There are 490 practice questions for this study session.

CFA Practice Question

For which of the following fixed-income securities would the reinvestment rate risk be the highest?
A. High coupon straight bonds
B. Long maturity bonds
C. Mortgage-backed securities
Explanation: Reinvestment rate risk arises when the investor receives cash flows from investments; these cash flows will then have to be reinvested. The greater these cash flows, the higher the reinvestment rate risk. Consequently, a mortgage-backed security not only pays back interest but repays a portion of the principal with every payment. This combination of principal and interest makes it the security that generates the greatest amount of periodic cash flow payments; it thus inherits the greatest amount of reinvestment rate risk.

User Contributed Comments 12

User Comment
DashingDude Good one
djop2002 since no numbers are provided in the question it is not possible to assess if MBS has the greatest amount of periodic cash flow payments. I think reinvestment risk is greater with MBS because prepayment of principal can occur which is not the case fot the others.
steved333 Also, the frequency of the cash flows means that there is more opportunity for a lower reinvestment as time goes on.
kellyyang tricky one!
jerasmus The absense of numbers makes this question impossible to answer.

What if the high coupon bonds had 50% coupon payments and the MBS had maturity of 50 years? Then the principal payments would be a VERY small part of the periodic payments, at least at the start. Anyone agree?
jerasmus The absense of numbers makes this question impossible to answer.

What if the high coupon bonds had 50% coupon payments and the MBS had maturity of 50 years? Then the principal payments would be a VERY small part of the periodic payments, at least at the start. Anyone agree?
ciji Jerasmus: again in the absence of the number of years for the high coupon bonds it would not be able to agree or disgree with your opinion.

Therefore in the absence of numbers, motgage backed securities seem to be the most appropriate answer.

You should think "in general".
ciji Jerasmus: again in the absence of the number of years for the high coupon bonds it would not be able to agree or disgree with your opinion.

Therefore in the absence of numbers, motgage backed securities seem to be the most appropriate answer.

You should think "in general".
yekky I definitely agree with Ciji. Jerasmus you may have a valid point but when there are no numbers given, think of it as generally speaking. The explanation the question provides is excellent - high coupons mean higher reinvestment risk as there is more money to be lost. However, with the MBS, not only do you have a risk of losing out on the interest payments but on the added principal as well. A good question to throw at us so prepare!
shiva5555 I think i was thinking interest rate risk. For interest rate risk, long maturity bonds have the greatest risk correct?
chunkychen The question needs to be specific regarding which type of MBS its referring to. The answer is only correct for Mortgage passthrough's.
ascruggs92 jerasmus, what you're saying make sense but the example you gave is so ridiculous it doesn't give what you said any validity
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