Chapter 9 - Investment returns and risk

Question 1

interest rate risk

key factors of interest rate changes

Answer 1

• interest rate risk is important for fixed-income or floating/variable rate securities
• factors may affect short term rates, while others affect the rates across the yield curve and thus the shape of it

factors

• econmic cycle - demand increases rates, recession decreases rates
• gov fiscal policy - issue gilts to fund a deficit, will push up medium and long term gilt yields
• gov monetary policy - quantative easing (QE), reduce short term rates. also, when gov purchases long dated bonds it impacts long term rates
• inflation expectations - inflation expected to rise, this will pushup longer term rates, typically leading to a steeper yield curve
• preference for liquid securities - in times of uncertainty, investors hold money in short term securities, pushing down short term rates

Question 2

credit risk

three types

Answer 2

important for bond investors or deposits with institutions

default risk - default on interest and capital on maturity

downgrade risk - market anticipates a bond downgrade from a ratings agency. higher yield will be required, this means price of the bond will fall

credit spread risk - flight to quality with uncertainity. this means corporate bonds tend to underperform gov bonds.

Question 3

result of high inflation

Answer 3

• deposits and fixed interest securities - erodes value of the capital and interest payments
• drop in demand for goods and services - cost of borrowing is more expensive

Question 4

compound interest formulae

FV =

r =

Answer 4

PV x (1+r)^n

[n√ (FV / PV)] - 1