Assignment Wk 5 (Autosaved).docx

# The consequence is that the prices of existing bonds

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higher coupon rates on new bonds in order to attract investors. The consequence is that the prices of existing bonds drop because investors prefer the newer bonds paying the higher rate. On the other hand, there's also interest-rate risk when rates fall because maturing bonds or bonds that are paid off before maturity must be reinvested at a lower yield. Inflation risk describes the risk that increases in the prices of goods and services, and therefore the cost of living, reduce your purchasing power. Let's say a can of soda increases from \$1 to \$2. In the past, \$2 would have bought two cans of soda, but now \$2 can buy only one can, resulting in a decline in the value of your money. Inflation risk and interest rate risk are closely tied, as interest rates generally rise with inflation. Because of this, inflation risk can also reduce the value of your investments. For example, to keep pace with inflation and compensate for the loss of purchasing power, lenders will demand increased interest rates. This can lead to existing bonds losing value because, as mentioned above, newly issued bonds will offer higher interest rates. Inflation can go in cycles, however. When interest rates are low, new bonds will likely offer lower interest rates. Currency risk occurs because many world currencies float against each other. If money needs to be converted to a different currency to make an investment, any change in the exchange rate between that currency and yours can increase or reduce your investment return. You are usually only impacted by currency risk if you invest in international securities or funds that invest in international securities. For example, assume that the current exchange rate of the U.S. dollar to British pound is \$1=0.53 British pounds. If you invest \$1,000 in a mutual fund that invests in the stock of British companies, this will equal 530 pounds (\$1,000 x 0.53 pounds = 530 pounds). Six months later, assume the dollar strengthens and the exchange rate becomes \$1=0.65 pounds. If the value of the fund does not change, converting the original investment of 530 pounds into dollars will return only \$815 (530 pounds/0.65 pounds = \$815). Consequently, while the value of the mutual fund has not changed in the local currency, a change in the exchange rate has devalued the original investment of \$1,000 into \$815. On the other hand, if the dollar were to weaken, the value of the investment would go up. So if the exchange rate changes to \$1=0.43 pounds, the original investment of \$1,000 would increase to \$1,233 (530 pounds/0.43 pounds = \$1,233). As with most risks, currency risk can be managed to a certain extent by allocating only a limited

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portion of your portfolio to international investments and diversifying this portion across various countries and regions. Liquidity risk is the risk that you might not be able to buy or sell investments quickly for a price that is close to the true underlying value of the asset. Sometimes you may not be able to sell the investment at all if there are no buyers for it. Liquidity risk is usually higher in over-the-counter markets and small-capitalization stocks. Foreign investments can pose liquidity risks as well. The
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