Risks of Investing in all Types of Bonds Finance Essay

When interest rates rise, bond prices fall; conversely, rates decline, bond prices rise. The longer the time to a bond's maturity, the greater its interest rate risks. This risk can be reduced by diversifying the durations of the fixed-income investments that are held at a given time. Interest rate risk affects the value ofA bondsA more directly than stocks, and it is a major risk to all bondholders.A As interest rates rise, bond prices fall.A The rationale is that as interest rates increase, the opportunity cost of holding a bond decreases since investors are able to realize greater yieldsA by switching to other investments that reflect theA higher interest rate.A

Example

For example,A a 5% bond is worth more if interest rates decrease since the bondholderA receives a fixed rate of return relative to the market, which is offering a lower rate of return as a result of the decrease in rates.A

Yield Curve Risk:

The risk of experiencing an adverse shift in market interest rates associated with investing in a fixed income instrument.A The risk is associated withA either a flattening or steepening of the yield curve, which is a result of changing yields amongA comparable bonds withA different maturities. Example For example, the Enron bonds fell when Enron declared themselves bankrupt. The restructured Enron Corporation fixed with their creditors, paying them around $0.14 per dollar. For bondholders this arrangement was of $140 for every $1000 face value of each bond.

For example the managers analyze prospective supply and demand for new issues on spreads in individual sectors or issuers to determine the whether be over weighted or underweighted.

Prepayment Risk:

Prepayment risk is the amount of potential that exists for an investor who do not receive the projected return from the transaction. Risk of this type is associated with any type of lending situation where interest is assessed on the balance, or where investors purchase bonds in anticipation of recovering the face value plus some type of interest from the venture. Example: Mostly in callable bonds the investors pay a premium with high interest rate take on prepayment risk. Additionally to being highly correlated with decreasing interest rates, mortgage prepayments are highly correlated with increasing home values, as increasing home values provide incentive for borrowers to trade up in homes or use cash-out refinance, both leading to mortgage prepayments

Reinvestment risk:

When interest rates are declining, investors have to reinvest their interest income and any return of principal, whether scheduled or unscheduled, at lower prevailing rates. Three factors affect this risk: Maturity: the yield to maturity measure for long-term coupon bonds tells little about the potential yield that an investor may realize if the bond is held to maturity. Coupon rate: the higher the coupon rate, the larger the size of the cash flows to be reinvested, and the bigger the reinvestment risk. Therefore a zero-coupon bond has zero reinvestment risk if held to maturity, and a premium bond has bigger reinvestment risk than a discount bond. Call, prepayment options and amortizing securities: the reinvestment risk is even greater for these kinds of securities. A callable bond has higher reinvestment risk than a standard bond, because it is likely that the cash flows of the callable bond may be received faster due to the call feature. Example: For example, suppose you had a nice, safe Aaa-rated corporate bond that paid you 4% a year. Then rates fall to $2%. Your bond gets called. You'll get back your principal, but you won't be able to find a new, comparable bond in which to invest that principal. If rates have fallen to 2%, you're not going to get 4% with a nice, safe new Aaa-rated bond.

Credit risk:

The risk of an unexpected, future decrease in credit quality that is a result of events such as a corporate acquisition or material changes in taxes, laws, or regulations.

Example:

Credit risk are predictable at some extend, when change the market condition, social, economic, political and operational requirements. Even taxation, heather change these are all the examples of credit risk.

Liquidity risk:

The risk of having difficulty in liquidating an investment position without taking a significant discount from current market value. Liquidity risk can be a significant problem with certain lightly traded securities such as unlisted options and municipal bonds that were part of small issues. Also called marketability risk. if the bond issuer's credit rating falls or prevailing interest rates are much higher than the coupon rate, it may be hard for an investor who wants to sell before maturity to find a buyer. Bonds are generally more liquid during the initial period after issuance as that is when the largest volume of trading in that bond generally occurs.

Currency and exchange-rate risk:

Currencies-the Euro, the dollar, pound sterling, etc.--move in relationship to one another. If you have investments in other currencies than your own, the risk is that the currency your bond is in will appreciate. When the bond's proceeds are converted back into your own currency, the proceeds will be worth less.

Example:

Suppose an investor in the United States purchases shares or bonds in a British company. There would be a huge risk that the value of the investment in dollars might be decrease or decline if the pound falls against the US dollar.

Inflation risk:

Inflation causes tomorrow's Euro, pound sterling or dollar to be worth less than today's; in other words, it reduces the purchasing power of a bond investor's future interest payments and principal, collectively known as "cash flows." Inflation also leads to higher interest rates, which in turn leads to lower bond prices. Inflation-indexed bonds are structured to remove inflation risk. Example: Imagine, for example, that buy a Treasury bond that pays interest of 3.32%. That's about as safe an investment as you can find. As long as hold the bond until maturity and the U.S. government doesn't collapse, nothing can go wrong unless inflation climbs. If the rate of inflation rises to, say, 4 percent, your investment is not "keeping up with inflation." In fact, you'd be "losing" money because the value of the cash you invested in the bond is declining. You'll get your principal back when the bond matures, but it will be worth less.

Volatility risk:

Volatility risks are understood to be the amount of threat to a given investment, based on conditions currently taking place in the market. This would include some indication that the value of an underlying security is about to enter into a period of fluctuation that will seriously impact performance of the investment. When deciding whether or not to buy a given option, an investor will normally wish to be made aware of the amount of volatility risk currently associated with the investment.

Example:

Contrarily, bond market volatility is harmful to convertible hedgers. Rapidly decreasing interest rates in 1992-1993 encouraged many companies to call their convertibles sooner than usual, in resultant premature loss of conversion premiums and accrued interest added to hedging difficulties. A static market teamed with a volatile bond market in 1994 caused created the worst possible scenario for convertible bond hedging strategies. The decrease in relative values between convertible and hedging underlying inventory meant extra losses. Fortunately, hedgers surviving in year 1994 have enjoyed several favourable years.

Event risk:

The risk that a bond's issuer undertakes a leveraged buyout, debt restructuring, merger or recapitalisation that increases its debt load, causing its bonds' values to fall, or interferes with its ability to make timely payments of interest and principal. Event risk can also occur due to natural or industrial accidents or regulatory change.

Sovereign risk:

The risk that the government issuing the bond will act in ways that negatively affect the value of the bond.

Example

International bonds have varying degree of risk. Fortunately the some rating agencies that evaluate U.S companies provide ratings for bonds issued by foreign corporations and sovereign nations, which certainly alleviates much of the guess work related to credit quality Q 02:

Put Option

An option content that gives the holder the right to sell a certain quantity of security to writer of the option, at a specified price up to a specified date. A put option is usually called PUT; it is a financial content between two parties, the writer (seller) and the buyer of the option.

Call option

An option contract that gives the holder the right to buy a certain quality which is usually 100 shares of underlying security from the writer of the option, at specified price up to a specific date called call option.

Bond Market

is also known as debt, credit and fixed income market, and is market where participants buy and sell debt securities which are in shape of bond. Markets consists of corporate, Government and agency, Municipal, Mortgage backed and Funding.

Bond Investor and Bond Issuer

Bond Yield

In bond yield the coupon interest rate is fixed, the bonds yields varies from day to day depending on current market conditions. Moreover the yield can be calculated in three different ways and different yields are described are as follows.

YIELD TO MATURITY (YTM)

It is being described as, if you are interested in buying a bond at a market price that is different from the bond per value. There are three numbers commonly used to measure the annual rate of return you are getting your investment: Coupon rate: Annual payout as a percentage of the bound par value Current yield: Annual payout as a percentage of the current market price you will actually pay YTM: Composted rate of return off all payout, coupon and capital gain. YTM is the best of the measure of the return rate. Whatever r is, if you use to calculate the present value of all payouts and then add up these present values, the sum will equal your initial investment. In an equation,

c(1 + r)-1A + c(1 + r)-2A + . . . + c(1 + r)-YA + B(1 + r)-YA = P

c = annual coupon payment (in dollars, not a percent) Y = number of years to maturity B = par value P = purchase price Suppose your bond is selling for £950, and has coupon rate of 7%; is matures in 4 years and the par value is £1000. What is theYTM? The coupon payment is £70 that's 7% of £1000, so the the equation will be,

70(1 + r)-1A + 70(1 + r)-2A + . . . + 70(1 + r)-YA + 1000(1 + r)-YA = 950

Find that r=8.53%

Current yield is £70/£950=7.737%

Bond Selling:

Discount Coupon Rate < Current Yield < YTM Premium Coupon Rate > Current Yield > YTM Par Value Coupon Rate = Current Yield = YTM

YIELD TO PUT (YTP)

The yield to put provision allows the bondholder to sell back the bonds to the issuer at a put price. The put provision is advantageous to a bondholder and not the issuer. A put is likely when prevailing interest rates are significantly higher than the coupon rate attachment to the bond. The yield to put is the rate of return if a bond is put to the issuer. For Example a bond matures after 10 years and pays a 6 percent semiannual coupon rate and is selling for $870. The yield to maturity is 7.90% and the first put price is $975 in 3 years. The yield to put is calculated using a financial calculator. The yield to put is 10.42%, which is greater than the yield to maturity (7.90%). Therefore, it is very likely that the investor would put this bond back to the issuer because yield to put is extremely greater than yield to maturity. It takes a greater return to erase the discount sooner which is why a bond selling at a discount sooner which is why a bond selling at a discount can be a positive to the bondholder. In other hand if, bond were selling at a $1095 (premium), the yield to maturity is 4.78%.

YIELD TO CALL (YTC)

The rate of return earned on a bond if it is called before its maturity date. If you bought a bond that was callable and the company called it, you would not have the option of holding it until it matured. Therefore, yield to maturity would not be earned. Q # 03 Hard peg : National currency (usually that of an industrial power). One country, in other words, "pegs" the value of its currency to the value of another currency. This is commonly done by countries with a history of monetary instability is used as a means of restoring and maintaining order. The U.S. dollar is frequently used for a hard peg by other smaller nations.

Soft Peg:

A currency that fluctuates in value frequently. Soft currencies are generally issued by governments that are less stable and/or have weaker economies than stronger currencies. As such, most soft currencies come from countries in the developing world. Central banks rarely hold reserves of foreign soft currencies as they do little or nothing to stabilize the local currency. A soft currency is also called a weak currency. b);An analysis of the difference between pegs and a fixed exchange rate regime. What Is an Exchange Rate? An exchange rate is the rate at which one currency can be exchanged for another. In other words, it is the value of another country's currency compared to that of your own. for example, the exchange rate forA U.S. dollarsA 1:5.5 Egyptian pounds, this means that for every U.S. dollar, you can buy five and a half Egyptian pounds. Fixed Exchange Rates A fixed, or pegged, rate is a rate the government sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged. For example, it is determined that the value of a single unit of local currency is equal to US$3, the central bank will have to ensure that it can supply the market with those dollars. In order to maintain the rate, the central bank must keep a high level of Conclusion Although the peg has worked in creating global trade and monetary stability, it was used only at a time when all the major economies were a part of it. And while a floating regime is not without its flaws, it has proved to be a more efficient means of determining the long-term value of a currency and creating equilibrium in the international market.

Dollarization:

Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency. The term is not only applied to usage of the United States dollar, but generally to the use of any foreign currency as the national currency. The major advantage of dollarization is promoting fiscal discipline and thus greater financial stability and lower inflation. Semi-Dollarization: A country will use both its own currency and the U.S. dollar interchangeably as legal tender. Lebanon and Cambodia are good examples of this. Unofficial Dollarization: For many countries in the developing world, the dollar will be widely used and accepted in private transactions, but it is not classified as legal tender by the country's government A currency Board is a monetary authority which is required to maintain a fixed exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exchange rate target. Fixed Exchange Rate Regime: Fixed exchange rate regime under which the government or central bank ties the official exchange rate to another country's currency (or the price of gold).The purpose of a fixed exchange rate system is to maintain a country's currency value within a very narrow band.Also known as pegged exchange rate.

Performance of dollarized countries.

The economic performance of unofficially and semiofficially dollarized countries has been highly variable, but generally unimpressive. The reason of use the dollarization: increases market access and integration The US often financially supports nations that dollarize. Dollarization works best for small, interdependent nations helps encourage foreign investment Low quality and hampered economic growth which cause high inflation and many other problems.

These countries come in this catagary:

Canada Central America and the Caribbean Mexico Brazil Argentina The rest of Mercosur: Bolivia, Chile, Paraguay, and Uruguay The Andean group: Colombia, Ecuador, Peru, and Venezuela.

Brokers are professionals who play an important role in mediating between a lender and a borrower. Brokers collect personal information about the client for the lender. There are many different types of brokers. Below are the more sought-after brokers: Mortgage broker: mortgage brokers guide customers through the process of selecting a suitable mortgage package with competitive package offers. They also offer financial advice on mortgage and property. Real estate broker: real estate brokers finds buyers for those wanting to sell real estate and finds sellers for those wanting to buy real estate. Forex broker: forex brokers are firms or individuals, who assist individuals or firms to trade in the foreign exchange market Stockbroker: a stockbroker is a person or company who buys and sells stocks on behalf of another person or company, and tries to match up buyers and sellers. Insurance broker: insurance brokers source contracts of insurance on behalf of their customers. An investor looking for an investment avenue will benefit greatly from using a broker, as brokers tend to be more up-to-date with trends and happenings in the market. Also as per law the broker has a fiduciary duty to advise the customer in the customer's best interest. Q#04

How financial globalization is effected by:

Deregulation:

Deregulation is when the government seeks to allow more competition in an industry that allows near-monopolies. For example, in the 1990's, the electric utility industry began to be deregulated to allow competition. In some cases this in fact occurred successfully. However, fraud occurred as well. On the other hand, the telecommunications and airlines industries were more successfully deregulated. This allowed more competition, and eventually lower prices for these services. However, many companies that could no longer compete went out of business, which had a negative effect on the economy.

Capital mobility:

Perfect Capital Mobility means that an enormours quantity of funds will be transferred from one currency to another whenever the rate of return on assets in one country is higher than in another. Capital mobility is effected by political power of banks. The bad news is that big banks retain significant political power. The good news is that the intellectual climate has shifted decisively against them.

The Introduction of common currencies:

For the first time since the fall of the Roman Empire most of Europe has a single, common currency. The US dollar faces the first challenge to its hegemony since it displaced the British pound sterling as the world's most important currency after the First World War. However, if the Euro is to assume a wider role it will have to flourish in its own continent and survive challenges to the stability of European economies first. The Formation Of Economic Communication and Trading blocks: The concept of trade blocks is crucial in the context of international trade. Trade blocks are free trade zones designed to encourage trade activities across nations. The formation of trade blocks involves a number of agreements on tariff, trade and tax. The activities of trade blocks have huge importance in the economic and political scenarios of the contemporary world. Over the years trading blocks have played a major role in regulating the trend and pattern of international trade. b)How the internet ,and technological advances in computing power and communication affects: Three important issues that are relevant to global banking: how market developments have shaped bank behaviour over time and elicited appropriate responses from financial sector supervisors; how market contestability is important for improving market efficiency in the changing environment; and how some degree of harmonization of standards internationally is necessary to facilitate effective market discipline. Market forces and the rationale of Basel II . Because global market forces are increasingly shaping the structures of national banking systems, supervision needs to be conducted in ways that harness market discipline. The importance of market contestability . Technological developments and international agreements on financial services are making financial markets ever more contestable. Effective market discipline depends on the harmonisation of standards . Global integration is creating a need for some degree of harmonisation in this area. Products and Services: Banknotes Bank drafts Bank checques Overdraft Letter of credit Safe deposit boxes ATM Mail Telephonic banking Online banking Mobile banking Video banking b) In the world's financial markets, four major characteristics:

Modern Financial Markets:

Elimination of tariffs and creation of free trade zones with small or no tariffs Reduce the transportation costs, especially resulting from the development of centralization Capital control Technologies that have as their primary characteristic the transfer of information, including more traditional media technologies, such as film, satellite television, and telecommunications. As societies and economies re-orient themselves around technologies, there are inevitable consequences For the domestic and global financial system reform take some characteristics: Trade balance Balance of payments External debts Foreign and foreign investment Currency and foreign exchange control The use of domestic and global financial resources for development purposes is becoming more and more important as access to foreign resources becomes increasingly difficult. In doing that the following are seen to be essential: 1. The deepen financial markets in the context of alternative institutional arrangements; 2. Measures to strengthen market-supporting financial infrastructure; 3. A new regulatory and incentive framework to advance market integration; 4. To improve the financial technology of both informal and formal finance to widen the scope of their operations. 5. Measures to develop linkages among segments.

 

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