Certified Financial Management Specialist Practice Exam

What is the risk of lower income from reinvested funds at maturity referred to as?

1. Liquidity Premium (LP)

2. Reinvestment Rate Risk

3. Maturity Rate Premium

4. Default Risk Premium (DRP)

The correct answer is: Reinvestment Rate Risk

Reinvestment rate risk refers to the possibility that the income generated from reinvested funds will be lower than anticipated when those funds reach maturity. This is particularly relevant for fixed-income securities, where interest payments may need to be reinvested at prevailing interest rates that can vary over time. If, at the time of reinvestment, the rates offered are lower than those at which the original investment was made, the investor faces the risk of receiving less income than expected in the future. This risk arises primarily in scenarios such as bond investments, where the cash flows from the bonds (like interest payments) must be reinvested. Changes in market interest rates can significantly impact the returns on those reinvestments. Understanding reinvestment rate risk is crucial for investors who rely on consistent and predictable income streams from their investments. The other terms mentioned relate to different types of risks. Liquidity premium refers to the additional yield that investors demand for holding assets that are not readily tradable. Maturity rate premium is not widely recognized as a defined financial term, and default risk premium pertains to the extra return that investors require to compensate for the possibility of a bond issuer failing to make payments. Therefore, reinvestment rate risk is the most appropriate choice