Comparing Reinvestment Risk and Interest Rate Risk
An investor faces reinvestment risk because of investing in a particular market. It affects all the stock in the market regardless of company or industry. Reinvestment risk is also referred to as “un-diversifiable” risk, which means that an investor cannot escape the risk by investing in a different stock in the same market. It is also the opportunity cost of putting money at risk.
Examples and protection mechanisms
All assets with correct prices will lie on the ‘security market line’. Any security away from this line will either be overpriced or underpriced. The security market line, therefore, shows the pricing of all assets if the market is at equilibrium. It is a measure of the required rate of return if the investor were to undertake a certain amount of risk. The investor has the option of reducing the risk of exposure by going for the less risky assets such as treasury bills and bonds in order to reduce this risk. The data indicates that as long as you need additional returns, there is an additional risk that is associated with it. The investor can decide to take calculated risk by just investing along the security market line. Any portfolio or asset on the security market line is less risky and worthy. Treasury bills and bonds are less risky since they have a fixed rate of return and a fixed period of investment. Every investor is assured of a return. Risk-averse investors undertake this kind of investment (Liu & Wang 2010).
Interest rate Risk
Interest rate risk is inherent to a security because of its unique nature. It can also be described as “diversifiable” risk. Diversifiable means that an investor can avoid reinvestment risk by avoiding the particular stock all together. Adding the Reinvestment and Interest rate risk will give in the total risk associated with a security (Das, Markowitz & Scheid 2010).
Examples and protection mechanism
Intel has two major interest rate risk factors in its financial statements. Therefore, it follows that the above case is one of the positively skewed distributions as indicated by the figures. A portfolio consisting of one share of index fund and a put option takes a positively skewed distribution since it is very uncertain. It is not possible to tell which direction the share price might take because shares are considered very risky. Since investment is often a risky venture, many investors take steps to ensure that they do not lose their money during investment. They try as much as possible to minimize such risks or otherwise hedge against such potential risk. Insurance is purchased to guard an investor against loss arising due to price fluctuations in the market. The distribution is less skewed since the risk factor has been minimized or taken into consideration by the investor who acquires this investment.
Durations of investments
A normal distribution is usually the ideal condition within which an investor can make a decision since the returns here are uniform and take a particular direction, which is at least known or predictable to the investor. Although in a real investment, there is no ideal condition, thus investors are forced to hedge or reduce their risks. Acquisition of insurance is necessary to guard the investor against losing his or her money, as well as investments (Elton, Gruber & Brown 2006) especially in the short-term. In the long term, investments have a way of evening out.
Das, S., Markowitz, H. & Scheid, J. (2010). Portfolio optimization with mental accounts. Journal of Financial and Quantitative Analysis, 45(1): 311-334.
Elton, E., Gruber, M. & Brown, S. (2006). Modern portfolio theory and investment analysis. New York: John Wiley.
Liu, Z. & Wang, J. (2010). Value, growth, and style rotation strategies in the long- run. Journal of Financial Service Professional, 4(1): 67-90.