Risks_associated_with_bond - In our earlier articles we had...

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Risks associated with bond In our earlier articles, we had introduced debt market instruments and measures of valuing debt instruments ( The different measures of debt ). We had also looked into some of the factors, which affect the pricing and valuations of bonds ( The yield curve ). Although debt market instruments offer safe returns, they are not entirely risk free. There are several risks associated, arising mainly from change in external factors. Change in interest rate is the most influential risk, which primarily affects bond prices. We had earlier analysed the impact of interest rate risk and effect of other factors like monetary policy, fiscal policy, economic growth and inflation on bond prices. The purpose of this article is to highlight some of the other market related risks, which also influence bond prices. Some of the key risks factors associated with bond valuations are listed as follows: 1. Interest rate risk 2. Reinvestment rate risk 3. Yield curve risk 4. Call and prepayment risk 5. Credit risk 6. Liquidity risk 7. Exchange rate risk 8. Risk associated with inflation and erosion of purchasing power 9. Risk due to political & regulatory events and government actions Interest rate risk: Since we had already mentioned about interest rate risk in our previous articles, we will not go in its detail analysis. But just to refresh our memories, there is an inverse relationship between changes in interest rates and bond prices. The value of a bond is the sum total of the present value of its fixed future cash flows, discounted at the appropriate current market interest rate. Therefore, when the interest rate increases, a bond's value drops and vice- versa. A bond with longer maturity and higher yield will normally have less impact on price due to change in interest rates. On the other hand, an instrument with shorter maturity and low yield will tend to have larger impact on its price. The price volatility for low maturity and low yield instrument would however be on the lower side, as future cash inflows are lower compared to bond with long maturity period. Maturity Date Coupon Rate (%) Last traded price (Rs) Years to Maturity Yield to Maturity (%) 22-Nov-07 6.8 74 5.9 22.7 15-May-06 6.8 84.5 4.4 15.7 26-Jul-03 6.5 90.1 1.5 12 1-Sep-02 11.2 102.6 0.6 9.7 13-Dec-10 8.8 103.9 8.9 6.7 22-Apr-05 9.9 107.6 3.3 5.9 24-May-13 9 108.4 11.4 4.6
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30-May-13 9.8 112.7 11.4 3.3 30-May-21 10.3 114.2 19.4 3 Source: NSE web site Let's take the practical example in order to understand the relationship between maturity, bond
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Risks_associated_with_bond - In our earlier articles we had...

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