Investors who attempt to reduce their risk of fluctuating market interest rates by holding only short-term instruments
A)will succeed as long as the short-term instruments are Treasury bills.
B)will fail because short-term instruments are affected more by fluctuations in market interest rates than are long-term instruments.
C)will expose themselves to reinvestment risk.
D)will incur large capital gains.

Question

Quizplus · Accepted Answer

Investors who hold only short-term instruments to reduce their risk of fluctuating market interest rates will be exposed to reinvestment risk. This is because when the short-term instruments mature, the investor will need to find a new instrument to invest in, which may have a different interest rate. If interest rates have declined, the investor will have to reinvest at a lower rate, resulting in a lower return. Alternatively, if interest rates have increased, the investor will have to reinvest at a higher rate, resulting in a higher return. Thus, the investor has no control over the interest rate at the time of reinvestment, which exposes them to reinvestment risk.

Investors Who Attempt to Reduce Their Risk of Fluctuating Market