Question

Distinguish between reinvestment risk and refinancing risk in interest rate management. Mention which risk is affected by interest rate increases and which by interest rate decreases.

Answer 1

Refinancing is the act of borrowing money to square off existing debts. Consequently, refinancing debt would make sense only if interest rates are decreasing as that would entail lower interest rate expenses on the new debt as compared to the older debt. The inability to borrow anew so as to square off old debt is known as refinancing risk. Refinancing risk would be higher in increasing interest rate scenarios as that would elevate a borrower's inability to replace his/her existing debt with a cheaper alternative debt.

Reinvestment Risk is the risk that arises from not being able to reinvest interest incomes at suitably higher investment rates. The reinvestment risk becomes elevated in decreasing interest rate scenarios as it increases an investors inability to find suitably high paying reinvestment options for the investors' interest income.