Week 2: Financial markets

Question 1

Bonds and risk

Answer 1

1. Default risk
   The issuer may not make the promised payments on time.
2. Inflation risk
   Inflation may turn out to be higher than expected, reducing the real return on holding the bond.
3. Interest rate risk
   Interest rates may rise between the time a bond is purchased and the time it is sold, reducing the bond’s
   price (i.e., capital losses).
4. Liquidity risk
   It might be difficult to sell a bond (convert it into cash)
5. Exchange rate risk (indirect risk)
   If bond is (and its fixed coupon payments are) denominated in foreign currency, payment in local
   currency is changing when exchange rate changes.

Question 2

Contagion effect

Answer 2

1998, Russia defaulted, and people los confidence in emerging market
countries in general (like Brazil).
* Demand increased, price increased, and
yields declined.
* Interest rate spreads b/c of higher
(default) risk premia

Question 3

European sovereign debt crisis impact on bond market

Answer 3

Yield spreads increased substantially, still are not consequent between countries.

Question 4

Why do bonds with the same default rate, liquidity and tax status but different maturity dates have
different yields?

Answer 4

–> Term structure of interest rates
The relationship among bonds with the same risk characteristics but different maturities is called the term structure of interest rates.

• Interest rates of different maturities tend to move together.
• Yields on short-term bonds are more volatile than yields on long-term bonds.
• Long-term yields tend to be higher than short-term yields.