Final answer:
The investor is exposed to reinvestment risk, specifically the risk of an interest rate decrease at the end of year 3. An investor holding a 3-year 5% coupon bond with a 5-year investment horizon is exposed to reinvestment risk, concerned about a potential interest rate decrease at the end of year 3. The correct answer is A.
Step-by-step explanation:
In this scenario, the investor is exposed to reinvestment risk, specifically the risk of a potential interest rate decrease at the end of year 3. Reinvestment risk refers to the uncertainty in the future returns an investor will earn by reinvesting the coupon payments received from the bond at a potentially lower interest rate.
An investor holding a 3-year 5% coupon bond with a 5-year investment horizon is exposed to reinvestment risk, concerned about a potential interest rate decrease at the end of year 3.
Consider an investor with a 5-year investment horizon, holding a 3-year 5% coupon bond. The kind of risk this investor is exposed to is reinvestment risk. This is because after the bond matures at the end of year 3, the investor will need to reinvest the principal and the final coupon payment. If the interest rates have decreased by that time, the investor may not be able to find a new investment that provides the same or higher rate of return as the original bond. Therefore, the correct answer is: reinvestment risk only; and she is concerned about potential interest rate decrease at the end of year 3.
The investor in this scenario is primarily exposed to **Reinvestment Risk,** and the concern is about the potential interest rate decrease at the end of year 3. Reinvestment risk arises when cash flows, such as coupon payments, must be reinvested at prevailing interest rates that are lower than the rate of the original investment. In the context of a 5% coupon bond with a 3-year maturity held by an investor with a 5-year horizon, the concern is that the coupons received at the end of year 3, if reinvested, might yield lower returns due to a decrease in interest rates. This risk is more pronounced when there's an expectation or fear that interest rates will decline, impacting the investor's ability to reinvest at the same rate.
The other options are not applicable in this context. Liquidity risk typically pertains to the ease with which an asset can be bought or sold in the market without causing a significant change in its price, and it is not the primary risk in the given scenario. The investor's concern about interest rate movements points directly to reinvestment risk, making option (a) the most relevant choice.