FI: Risks of investing Flashcards
Risks =
Interest rate risk (duration)
Yield curve risk
Call risk
Prepayment risk
Reinvestment risk
Liquidity
notes:
yield curve risk is related to changes in the shape of the yield curve (interest rate risk, represented by duration, assumes equal shifts across nodes of the curve)
Reinvestment risk is essentially the risk behind call and prepayment. There is a trade off between reinvestment and interest rate risk ie. a zero has no reinvestment risk as there are no coupon cash flows, but duration is greater.
Risks #2 =
(unexpected) Inflation risk
Volatility risk
Event risk
Sovereign risk
Echange rate risk
inflation risk: can be thought of as purchasing power risk - greater than expected inflation will reduce the future value/purchasing power of cash flows (increase in nominal rates from inflation will decrease bond prices)
vol risk applies to securities with embedded options - changes in interest rate vol can change the value of these options
Event risk - risks outside financial markets ie natural disasters
Sovereign risk - credit risk of a sovereign bond issued outside the investor’s home country
Market Yield vs Bond Value =
Relationship of coupon and duration =
between two identical bonds, the one with the highest coupon will have the lower duration
MORE CASH FLOWS ARE EARLIER
Callability/putability =
call - limits the upside for a bond’s price
less sensitive to interest rates than an otherwise identical option free bond
put - limits the downside of a bond’s price
less sensitive, same as callables
BOND CHARACTERISTICS CHEAT SHEET =
Value of a callable =
= value of option free bond - value of embedded call option
Call options are worth more when the bond’s price closer to the call price (at higher prices, lower yields)
when yield is lower and price is higher the difference between a callable and non callable will be greater
Duration for a floater =
incl cap risk
and the fixed spread
limited due to coupon reset
will be greater the longer the reset period
cap risk: if there is a cap on the coupon rate and market yields are higher, the bond will trade at a discount and now be more interest rate sensitive
if factors change, the spread may over or undercompensate the holder - ie if the company’s credit risk improves the bond may trade up to a premium.
dollar duration/DV01 =
+duration of a zero
+duration of a floater
Note, this makes the regular duration equivalent to the change in bond price for a 1% change in yield (the denominator is 1)
for a zero, DURATION IS APPROXIMATELY EQUAL TO MATURITY
for a floater, DURATION IS APPROXIMATELY EQUAL TO THE RESET PERIOD
Interest rates and call provisions/prepayment options =
a) these increase uncertainty of cash flows
b) these become more likely when interest rates fall - more principal may be returned when reinvestment opportunities are less attractive (when rates rise you’ll get less principal back, although reinvestment opportunities are more attractive)
c) less potential price appreciation - explicit for callables, given the call price; prepayables don’t have a call price but behave in a similar way.
Reinvestment risk =
increases with
a) higher coupon
b) amortizing securities
c) callables
d) prepayment options
Types of credit risk =
default, credit spread, downgrade risk
Default risk: lower rated bonds have more default risk
Credit spread risk: the default risk premium required in the market for a given rating may increase - this would decrease price
nb credit spread is difference between yield on a tsy and the yield on a bond with credit risk.
Downgrade risk: risk that a credit rating agency will decrese the rating of a bond (also upgrade is possible)
Liquidity Risk =
Bid-ask-spread
Marking-to-market
NOTE THAT LOW LIQUIDITY AND HIGH LIQUIDITY RISK ARE USED INTERCHANGEABLY
less liquidity - more compensation required by the market - bond price decreases
bid ask - indication of liquidity as the difference between what dealers will buy and sell at
marking-to-market - difficult if liquidity is low and it is hard to get prices (bids) on a security - may be an issue for
a) institutional investors need prices for performance/reporting/regulatory reqs
b) collateral securities need to be priced, affecting the cost of funding (ie for repos this will lead to a higher cost of funding)
Vol risk and put/call options =
increased interest rate vol increases value of put and call options - these options are more likely to be able to be exercised.
for a CALLABLE increased interest rate vol will DECREASE PRICE - an increase in IR vol is ‘volatility risk’
note: value = option free bond val - call option val
for a PUTABLE decreased interest rate vol will DECREASE PRICE - a decrease in IR vol is ‘volatility risk’
note: value = option free bond val + put option val
Event risk =
natural disasters
corporate restructuring ( spinoffs, LBOs, M & A) - may affect company val and debt val (due to change in cash flows/underlying assets used as collateral) - can result in downgrades and effects across the industry
Regulatory issues
