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CFA Level I · CFA Level I Exam · Interest Rate Risk and Return

An investor buys a fixed-rate bond with a Macaulay duration of 4.2 years and a planned holding period of 6 years. Immediately after purchase, market yields rise by a one-time parallel shift. The investor's realized horizon yield will most likely be:

The realized horizon yield will most likely be higher than the original yield. Because the Macaulay duration is shorter than the holding period, reinvestment risk dominates, so a rise in yields increases reinvestment income by more than it reduces the bond's sale price.

  1. Aequal to the original yield.
  2. Blower than the original yield.
  3. Chigher than the original yield.Correct

Explanation

The Macaulay duration of 4.2 years is shorter than the 6-year horizon, so reinvestment risk outweighs price risk. After a yield rise, the gain from reinvesting coupons at higher rates exceeds the price loss at the sale date, so the realized return is above the original yield. It would equal the original yield only if the horizon matched the Macaulay duration.

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