Lesson 3 of 5 · 13 min
Reinvestment risk, price risk and the duration gap
Reinvestment risk and price risk offset each other, and which one dominates depends on whether your investment horizon is longer or shorter than the bond's Macaulay duration.
In short
- Reinvestment risk: falling rates lower the future value of reinvested coupons. Price risk: rising rates lower the sale price.
- The two risks move in opposite directions for the same rate change, so they partly cancel.
- Long horizon → reinvestment risk dominates. Short horizon → price risk dominates.
- Macaulay duration is the horizon at which the two effects offset for a one-time, immediate, parallel shift in rates.
- Duration gap = Macaulay duration − investment horizon. Positive gap → fear rising rates; negative gap → fear falling rates; zero → roughly immunized.
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