Chapter 2 - Chapter 2 Risks Associated with Investing in...

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1 Chapter 2 Risks Associated with Investing in Bonds
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2 Plan of the lecture Risks associated with investing in bonds Interest rate risk Yield curve risk Call and prepayment risk Credit risk Sovereign risk
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3 Risks associated with investing in bonds Many risks are involved in bond investments: Interest rate risk Yield curve risk Call and prepayment risk Reinvestment risk Credit risk Liquidity risk
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4 Risks associated with investing in bonds Many risks are involved in bond investments (continued from the previous slide): Exchange rate risk Inflation risk Volatility risk Event risk Sovereign risk
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5 Risks associated with investing in bonds Reinvestment risk The cash flows (coupon and principal) from fixed income securities may have to be reinvested at lower rates, thus reducing the returns to an investor (e.g., callable bonds ) Liquidity risk The sale of a fixed income security may have to be made at a price less than fair market price due to a lack of liquidity (as indicated by a wider bid-ask spread ) The bid price (the price at which a dealer buys a security) The ask price (the price at which a dealer sells a security)
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6 Risks associated with investing in bonds Exchange rate or currency risk The uncertainty about the value of foreign currency cash flows in terms of domestic currency Inflation or purchasing power risk The uncertainty about the amount of goods and services that the cash flows from a fixed income security can purchase
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7 Risks associated with investing in bonds Volatility risk impacts the value of bond with embedded options . For example: Increase in yield volatility Decrease in yield volatility Price of callable bond Price of callable bond Price of putable bond Price of putable bond (See the next slide for a recap of the definition of volatility.)
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8 Risks associated with investing in bonds Variance and standard deviation (recall from ADMS3530 ) Variance : The probability weighted average of squared deviations from the mean Standard deviation : The square root of the variance Both standard deviation and variance are measures of volatility
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9 Risks associated with investing in bonds Event risk is due to for example: a natural disaster a takeover, merger and acquisition, and corporate restructuring etc. changes in government regulations
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10 Interest rate risk Interest rate risk is the risk that the price of a bond will decline when interest rate rises . This is a major risk faced by bond investors There is an inverse relationship between bond price and interest rate level:
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Chapter 2 - Chapter 2 Risks Associated with Investing in...

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