Subscribe

Reinvestment Risk

Reinvestment risk is the risk that an investor will have to reinvest future cash flows at a lower return due to interest rate declines. In the context of securitisation, reinvestment risk arises when investors receive cash flows from the underlying assets, such as mortgage payments or interest payments, and they have to reinvest those cash flows at a lower interest rate.

There are a number of factors that can contribute to reinvestment risk, including:

  • Interest rate volatility: If interest rates decline, investors will have to reinvest their cash flows at a lower interest rate.
  • The length of the securitisation: The longer the term of the securitisation, the greater the risk of reinvestment risk.
  • The type of underlying assets: The type of underlying assets can also affect the risk of reinvestment risk. For example, mortgage-backed securities are more sensitive to interest rate changes than other types of securitisations.

Reinvestment risk can have a significant impact on the return on an investment. If interest rates decline, investors may have to reinvest their cash flows at a lower interest rate, which will reduce their return.

Here are some applications of reinvestment risk in securitisation:

  • Mortgage-backed securities: Mortgage-backed securities are typically issued with a fixed interest rate. This means that investors will receive a fixed amount of interest payments each month. If interest rates decline, investors will have to reinvest their cash flows at a lower interest rate, which will reduce their return.
  • Collateralized debt obligations: Collateralized debt obligations (CDOs) are typically issued with a floating interest rate. This means that the interest rate on the CDOs will fluctuate with market interest rates. If interest rates decline, the interest rate on the CDOs will also decline, which will reduce the return on the investment.

Reinvestment risk is an important consideration for investors in securitisation. Investors need to understand the risk of reinvestment risk and how it can affect their investment.

x