SIE practice questionmediumRisk — Call Risk
An investor who purchases a callable bond faces call risk, which means:
- AThe bond's coupon payments may be reduced
- BThe bondholder must sell the bond back to the issuer at a loss
- CThe bond may be called for additional investment by the issuer
- DThe issuer may redeem the bond before maturity, typically when interest rates have declined, forcing the investor to reinvest at lower rates✓ Correct answer
Explanation
Why D — The issuer may redeem the bond before maturity, typically when interest rates have declined, forcing the investor to reinvest at lower rates
Call risk is the risk that an issuer redeems a bond before maturity, typically when rates fall, allowing the issuer to refinance at lower rates. The bondholder then must reinvest the returned principal at the now-lower prevailing rates, reducing future income. Bonds are called at the call price (usually par or a slight premium), which may be below the market value the bondholder could have realized by continuing to hold.
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