bond market risk ( final )

8/11/2019 Bond Market Risk ( Final )

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2/14

DEFINITION: A lon g term debt in s t ru m ent in w hic h abo rrow er agrees to m ake payment o f pr inc ip le andin te res t , on sp ec i f ic da tes to th e holders of the bon d.


3/14

Prim ari ly traded in th e ov er-the-cou nt er (OTC)market .

Most bo nds a re owned by and t raded am on g la rgef inanc ial ins t i tu t ions .

Ful l in form at ion o n b on d t rades in the OTC marke t i sno t pub l i shed , bu t a representa t ive grou p of b ond s i sl i s ted and t raded o n the bo nd d iv is ion of the B.S.E .


4/14

All inv es tm ents offer a ba lance b e tween r i sk andpo tent ial return . The r isk is the chanc e that yo u w il l los eso m e or al l the mon ey y ou inves t . The return i s the

m oney you s t and to m ake on the inves tm en t . Higher the re turns , h ig her the r isk and vic e versa . The bon d m arke t i s no except ion to th i s ru le . Bo nds in

genera l are con s idered less r i sky than s tock s . Reason sfor th i s inc lud e:

1. Bo nds c arry the prom ise of the ir is su er to re turn theface va lue of the secur i ty to the holder a t m atur i ty ; s tock shave no s uch prom ise f rom the ir i s suer.

2. Most b on ds p ay investo rs a f ixed rate of in teres tinco m e tha t i s al so b acked b y a prom ise f rom th e issu er.


5/14

DEFINITION:Int erest rate ris k is r i sk to the earning s orm arket va lue of a po r t fo l io du e to unc er tain fu ture in teres trates.

Like al l bon ds , corp ora tes tend to r i se in va lue wh eninterest rates fal l , and th ey fal l in value wh en interestrates r ise . Usu al ly, the lo ng er th e m aturi ty, the g reater thedegree of pr ic e volat i l i ty.

When in teres t ra tes r i se , new issues c om e to m arket w i thhigh er y ields th an o lder secur i t ies , m aking tho se o lder

ones w or th less . Henc e , the i r pr ices go do wn . When in teres t ra tes decl ine , new b on d iss ues com e to

m arket wi th low er y ields th an o lder secur i t ies , m akingtho se older, hig her-yielding o nes w orth m or e. Hence,the i r pr ices go u p.

Variou s econ om ic forc es affec t the level and d i rec t ion of
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6/14

DEFINITION :Cal l r i sk is the r isk that a bo nd issu er wi l l

redeem i ts b on ds b efore they m ature . Som e bon ds are cal lable , that i s , the issu er has the r ight to

ca l l, o r b uy back a ll o r so m e of the bond s b efore theym ature . This o f ten happ ens w hen in teres t ra te r isk ra tes fa ll .For exam ple , con sider a c a l lable 10-year, 10% co up on bo ndissu ed by XYZ Com pany. Presu m ably, XYZ Com pany issu edthe debt a t pr evai l ing m arket rates . Bu t as t im e passes ,m arket rates m ay change. If ra tes fa l l to 5% wh i le the bond sare ou ts tanding , XYZ Com pany w ould be pay ing tw ice thego ing in teres t ra te . Clear ly, th is s i tuat ion co sts XYZCom pany m on ey, and i f i t can cal l the debt and re issue i t atthe low er 5% rate, i t wi l l p rob ably do so .

Call r i sk leads to re inv estm ent r isk . In o ur exam ple , XYZCom pany ' s cal l p rov is io n m eans bon dho lders no longerhave the pro m ise of 10 years o f 10% interes t paym ents . So, i fXYZ Com pany do es ca ll i t s bon ds , bond holders w i l l rece ivetheir pr inc ipal back (plus a cal l prem ium ), bu t then they w i l lhave to re invest that m on ey in a low er in teres t ra teenviron m ent . It may then be di ff icul t , i f not im po ssib le , to


7/14

DEFINITION: Reinv estm ent r is k is th e ch anc e that aninves tor w i l l no t be ab le to reinves t cash f low s f rom aninv estm ent at a ra te equal to the investm ent ' s cu rrentrate of r eturn .

For examp le, con s ider a Com pany XYZ bond wi th a10% y ield to m atur i ty (YTM). In o rder fo r an inv estor toactual ly receive the expected y ield to m atur i ty, sh em ust re inves t the coup on paym ents sh e receives at a10% rate. This is no t a lways po ss ible . If the inv estor

co uld o nly re inv est at 4% (say, because m arket return sfell af ter the bo nd s w ere iss ued) , the investo r ' s actualretu rn on the bond inves tmen t w ou ld b e low er thanexpected.


8/14

An unu sua l s i tuat ionw here sh or t -termin terest rates are

h igher than long - term rates.

In th e early 1980s,wh en s ho r t -t erminterest ra tes w erearou nd 20%, w hilelon g-term ra tes w entup to on ly 16% or17%.


9/14


10/14

DEFINITION: Credit r isk is th e chanc e that a bo ndi s sue r wi l l no t m ake the coupon payment s o r p r inc ipalrepaym ent to i t s bo ndh olders . In o ther word s , i t i s thech ance the issu er wi l l defaul t .

Many fac tors can inf luence an i ss uer 's c red i t r i sk andin varying degrees . Som e exam ples are po or o r fal l ingcash f low f rom op erat ions , r is ing in te res t rates o rch anges in th e nature of the marketplace thatadversely affect the issu er (su ch as a change in

techn olog y, an increase in c om pet itors , o r regula torychanges).

All bo nds , except for th ose i ssu ed by the Ind iangov ernm ent , car ry so m e cred i t r i sk . This i s o ne reason

corpora te bon ds almos t a lways h ave h ighe r couponp a m e n t am o u n t s t h an o v er n m en t b o n d s .


11/14

DEFINITION: Liqu idi ty r isk is the r isk th at a co m pany o rbank m ay be un able to m eet sho r t term f inancia l demands .This usua l ly occu rs du e to the inab i l ity to c onver t asecur i ty o r hard asset to cash.

Liquid i ty r i sk general ly a r ises wh en a bus iness o r

indiv idu al w i th im m ediate cash needs , ho lds a valuableasset that i t can not t rade or se l l at m arket value du e to alack of bu yers , or due to an ineff ic ient m arket wh ere i t i sdi ff icul t to br in g b uy ers and s e l lers together.

For exam ple, co ns ider a Rest 1,00,00,000 ho m e with nobuy ers . The hom e obvious ly has va lue, bu t d ue to m arke tco nd i t ions a t the t ime, there m ay be no in teres ted bu yers .In be t ter econo m ic t imes wh en market cond i t ions im prov eand dem and inc reases , the hou se may sel l for wel l abo ve

that price. However, due to the home owners need of cashto m eet near term f inancia l demand s, the ow ner m ay be


12/14

DEFINITION: Exc han ge-rate r isk , also c al led c ur renc yr isk , i s the r isk th at ch anges in th e value of cer taincur renc ies w i l l reduce the va lue of in ves tmentsdenom inated in a fore ign c ur rency.

Exch ange-rate r isk m at ters b ecause exc hang e ratesaffec t th e am ou nt o f m on ey th e inves tor ac tua lly s eesat the end o f the day, and this in turn determin es wh atthe investo r ' s ra te of re turn ul t im ately is .

How ever, exch ange-rate r isk can c reate op po rtun i t iesbecause the in teres t rates between tw o co un tr ies of tenref lect exp ected ch anges in th e exc hang e rate betweenthem . This is b ecause wh en interes t ra tes inc rease in apar t icu la r cou nt ry, in terna t ion al m oney f low s in to tha t

cou nt ry to capture the h igh er y ields . This pus hes the'


13/14

DEFINITION: Inf lat ion r isk , also c al led p ur ch asin gpow er r isk , i s the chance tha t the cash f low s f rom aninves tm en t w on ' t be wor th a s m uch in the fu tu rebecause of changes in purc has ing po wer due to

inf la t ion. Inf la t ion caus es m on ey to lose value, and any

inves tm ent tha t involves cash f low s ov er t ime i sexpo sed to th i s in f lat ion r i sk . The con sequences of th i s

can be ser iou s: The inv estor earns a low er re turn th athe or sh e or ig inal ly expec ted , in so m e cases caus ingthe inv es tor to w i thdraw som e of a por t fo l io ' s p r inc ipa li f he or sh e is d ependent on i t fo r inco m e.

It i s im po r tan t to no te that in f la tion r i sk i sn ' t the r i skthat there wi l l be inf la t ion , i t i s th e r isk th at inf lat ion w il l


14/14

DEFINITION: Prob abil i ty th at the gov ernm ent of aco unt ry (or an agency backed by th e go vernm ent )wi l l refuse to co m ply w i th the term s of a loanagreement.

This u sua lly oc curs dur ing econo m ical ly d i ff i cu l t o rpo l i t ical ly vo lat i le t im es or that a centra l bank w il limp ose fore ign exch ang e regula t ions th a t wi l l redu ceor n egate the value of fo reign exc hang e co ntracts .

bond market risk ( final )

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