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# Finance Dictionary - R Terms

# Reinvestment Rate Risk

The return that an investor receives from a bond investment equals the bond’s yield to maturity or effective annual rate only if the coupon payments can be reinvested at a rate equal to the bond’s yield to maturity. Since the form of the interest facto in the bond price equation, (1 þ r)m assumes that all the cash flows are reinvested at the periodic rate r for m periods; should future coupons be reinvested at a lower rate, the investor’s actual yield will be less than the bond’s yield to maturity. Therefore, reinvestment rate risk occurs when fluctuating interest rates cause coupon payments to be reinvested at different interest rates. Another illustration of reinvestment rate risk occurs when maturing bank CDs are rolled over into new CDs. The risk benefits the investor when the new CD rate is higher than the maturing CD rate; it works against the investor when the new CD rate is lower. Azero coupon bond, a bond which pays no explicit interest, eliminates reinvestment risk. This is the primary reason for the popularity of zero coupon bonds in the investors.