Accredited Wealth Management Advisor Practice Exam

What type of risk is Dan's bonds most likely facing after interest rates have fallen?

1. Interest rate risk

2. Default risk

3. Reinvestment rate risk

4. Financial risk

The correct answer is: Reinvestment rate risk

When interest rates fall, investors like Dan face reinvestment rate risk. This risk arises because the cash flows from the bonds, such as coupons or returns on principal when the bonds mature, will need to be reinvested at the new, lower interest rates. This situation can lead to lower overall yields for the investor because they are unable to reinvest their earnings at rates that match the higher returns of the existing bonds that they hold. For example, if Dan has a bond that pays a 5% coupon and interest rates fall to 3%, any interest or capital he receives from the bond may need to be reinvested at this lower prevailing rate. As a result, the overall potential return on Dan's investment could decrease. This scenario is particularly relevant for fixed-income securities like bonds, where the cash flows are predictable but the reinvestment opportunities fluctuate based on market interest rates. In contrast, interest rate risk pertains to the fluctuation in the bond's market value caused by changes in interest rates, while default risk relates to the possibility that the bond issuer may fail to make required payments. Financial risk concerns the overall financial health of the issuer and its ability to stay solvent, which is less relevant in this context of falling interest