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Refinancing risk with example.

Refinancing risk is the degree of risk that the desired outcome of a particular

financial transaction will not come to pass. For investors who acquire mortgage-

backed securities, the risk is that the mortgages which support the securities

will be paid off early, resulting in a lower amount of interest income. A borrower

also experiences some degree of refinancing risk in terms of the ability to

refinance the loan at a more competitive rate at some point in the future. In both

examples, refinancing risk results in an inability to achieve the returns desired

when the transaction was first implemented.

Refinancing risk is the chance that the costs for renewing a debt facility will be

higher than expected. Say, for example, that a company owes $100,000 on a

short-term, interest-only loan. At maturity, if the company can't pay off the debt,

it must be refinanced at whatever rate is available, given prevailing economic

conditions. There's a risk that the best rate available will be higher than the

company can afford.

Reinvestment risk with example.

The possibility that the cash flows produced by an investment will have to be

reinvested at a reduced rate of return. For example, the owner of a certificate of

deposit faces the risk that lower interest rates will be in effect when the

certificate matures and the funds are to be reinvested.

A risk that an investment, usually a bond, will be paid off early and that the

money earned may not be able to be reinvested in a security with a comparable

return. Suppose one invested in a bond with coupon payment of 4%. However,

the issuer calls the bond and pays the par value. The investor has made a

profit, but interest rates have fallen and now he/she may only purchase a bond

with coupons of 2.5%. Theoretically, one might purchase a mortgage-backed

security or other investment in which all the mortgage holders backing the MBS

may pay back their mortgages early, exposing one to reinvestment risk.

However, in reality, this risk exists primarily in callable bonds and certificates of

deposit.

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Reinvestment risk is one of the main genres of financial risk. The term

describes the risk that a particular investment might be canceled or stopped

somehow, that one may have to find a new place to invest that money with the

risk being there might not be a similarly attractive investment available. This

primarily occurs if bonds (which are portions of loans to entities) are paid back

earlier then expected.

When a person invests, there can be several categories of risk involved. One of

those is referred to as reinvestment risk. This situation arises when invested

funds generate revenue that once reinvested will be subject to a lower rate of

return. This term is commonly used when considering fixed income investments

that have set maturity dates such as certificates of deposit (CDs) and bonds.