Friday, October 31, 2008


Risk Management Summary.

In the last 11 posts (4 to 14 posts)we have described 12 risks associated with investing in fixed income securities.No all securities or investment strategies expose the investor to all of the risks we have discussed.As the instruments & portfolio management strategies are discribed in more detail throughout these posts.we present some of the importent details only.

To help our users we summarised the details as given below.

  • Interest rate risk(market risk).
This is the major risk & this posts has considered this in detail.It is measured by duration & convexity.

  • Reinvestment risk.
Caused by variability in the reinvestment rate greatest for high-coupon bonds & long holding periods. Offsets interests rate risk to a degree.
  • Call risk.
Three disadvantages are faced by an investor holding a callable bond,
1. Uncertain cash flows.
2. Reinvestment risk if bond is called
3. Reduced capital appreciation potentia
Compensation via higher yield but difficult to determine the premium required
  • Default risk (Credit risk).
Gauged by quality ratings bond value will be affected by
-Changes in perceived default risk
-Changes in spred demanded by market for a given level of default risk.
  • Liquidity risk (Marketablility risk).
Ease with which bond can be sold at or near its value.Measured by the size of the bid ask spread.
  • Inflation risk (purchasing power risk).
Caused by the variation in the value of cash flows from the bond due to inflation.To the extent that interest rates reflect the expected inflation rate ,floating rate bonds have less risk.
  • Exchange rate risk (currency risk).
Occurs when a bond is denominated in a forign currency & hence cash flows in currency are uncertain.
  • Political or Country risk.
This risk occurs where there is uncertainty about the political environment or the economic system in the country of issue.
  • Yield curve risk.
This is the risk of a non parallel shift in the yield curve.
  • Industry or Sector risk.
This is that element of risk that arises because of specific features of the issuer's industry or sector.
  • Event risk.
This is the risk of price movements due to specific but unpredictable events such as stock spits,ipos,exchange listing,unexpected word or economic events & the announcement of significant accounting changes.
Summarized here are other terms that you may encounter in your references.
FLOATING OF BONDS-Coupon rate reset periodically benchmark could be a financial index or the price of a commodity.
INVERSE FLOATERS-Coupon rate moves in the opposite direction to the benchmark.
DEFERRED COUPON BONDS-No coupon paid for a specified number of years.
PUT PROVISIONS-Bondholder has right to sell issue back to issue at par value.
CONVERTIBLE BOND-Bondholder has right to exchange bond for a specified number of the issue's shares.
EXCHANGEABLE BOND-Bondholder has right to exchange bond for a specified number of common stock shares of a corporation different from the issuer of the of the bond.


Event Risk.
Occasionally, the ability of an issuer to make interest & principal payments is seriously & unexpecttedly change by a nature or industrial accident or a takeover or corporate restructuring.These risks are referred to as event risk.The cancellation of plans to build a nuclear power plant illustrates the first type of event in relation to the utility industry.
As example of the second type of event risk is the takeover in 1988 of RJR Nabisco for $25 billion via a financing technique known as a leveraged buyout (LBO).In such a transaction,the new company incurred a substantial amount of debt to finance the acquisition of the firm.Because the corporation was required to service a substantially larger amount of debt, its quality rating was reduced to noninvestment grade quality.As a result, the change in yield spread to a benchmark Treasury,demanded by investor because of the LBO announcement, increaased from about 100 basis pints to 350 basis pints.
There are also spillover effects of event risk on other firms. For example if there is a nuclear accident, this will affect all utilities producing nuclear power.
Sector Risk.
Bonds in different sector of the market respond differently to environmental changes because of a combination of some or all of the above risks, as well as others. Examples include discount versus premium coupon bonds.The possibility of adverse differential movement of specific sectors of the market is called sector risk.
Other Risks.
The various risks of investing in the fixed income markets reviewed in this chapter do not represent the entire range of risks.In the market place, it is customary to combine almost all risks other than market risk (Interest rate risk) & refer to it as basis risk.


Political or Legal Risk.
Sometimes the government can declare withholding or other additional taxes on a bond or declare a tax -exempt bond taxable.In addition a regulatory authority can conclude that a given security is unsuitable for investment entities that it regulates.These actions can adversely affects the value of the security.Similary,it is also possible that a legal or regulatory action affects the value of a security positively.The possibility of any political or legal actions adversely affecting of a security is known as political or legal risk.
To illustrate political or legal risk,consider investors who purchase tax exmpt municiple securities.They are exposed to two types of political risk that can be more appropriately called tax risk is that the federal income tax rate will be reduced.The higher the marginal tax rate, the grater the value of the tax-exempt nature of a municipal security.As the marginal tax rates decline, the price of a tax exmpt muncipal security will decline.
For example ,In 1986 there were proposals to reduce marginal tax rates.As a result, tax-exmpt muncipal bonds began trading at law prices.The second type of tax risk is that a muncipal bonds issued as tax-exmpt will evenatually be declared taxable by the Internal Revenue Service. This may occur because many municipal (revenue) bonds have elaborate security structures that could be subject to future adverse congressional actions & IRS interpretations.As a result of the loss of the tax exemption ,the municipal bonds will decline in value in order to provied a yield comparavle to similar taxable bonds.
For example , In June of 1980,The battery park city authority sold $ 97.3125 million in constriction loan notes.
At the time of issuance the legal counsel thought that the interest on the note would be exempt from federal income taxation,in November of 1980,however the IRS held that interest on those notes was not exempt resulting in a lower price for the notes the issue was not resolved until September 1981 when the authority & the IRS signed a formal aggrement resolveing the matter so as to make the interest on the notes tax-exempt.


Exchange rate or Currency Risk.
A non dollar-denominated bond (i.e. a bond whose payments occur in a forign currency) has unknown US doller cash flows.The dollar cash flow are dependent on the forign-exchange rate at the time payments are recived.For example Suppose & invester purchases a bond whose payments are in Japanese yen depreciates relative to the US doller,than fewer doller will be recived.The risk of this occurring is referred to as exchange rate risk of course,shoud the yen appreciate relative to the US doller the invester will benifit by receiveing more dollers.
For example ,if a US invester purchase German goverment bonds denominated in deutsche market,the proceeds received from the sale of that bond prior to maturity will depends on the level of interest rates in the German bonds market,in addition to the exchange rate.
Valatility Risk.
The price of a bond with an embedded option depends on the level of interest rates & factor that influence the value of the embedded option.One of the factor is the expected volatility of interest rates Specifically the value of an option rises when expected interest rate volatility increase.In the case of a callable bond or mortgage banked security.Because the invester has granted an option to the borrower,the price of the security falls because the invester has given away a more valuable option.The risk is that change in volatility will aversely affect the price of a security is called volatility risk.

Thursday, October 30, 2008


Inflation or Purchasing power Risk.
Inflation risk or purchasing power risk,arises because of the variation in the value of cash flows from a security due to inflation as measured in terms of purchasing power.
For example , If an investor purchases a five year bond in which he or she can realized a coupon rate of 7%,but the rate of inflation is 8%,then the purchasing power of the cash flow has declined.
For all but adjustable or floating rate bonds, an investor is exposed to inflation risk because the issuer promises to make is fixed for the life of security.To the extent that interest rates reflect the extend to make is fixed for the life of the security.Floating rate bonds have a lower level of inflation risk.
Marketability or Liquidity Risk.
Marketability risk, or liquidity risk,involves the case with which an issue can be sold at or near its true value.The primary measure of marketability,liquidity is the size of the spared between the bid of price and the offer price and the offer quoted by a dealer.The greater the dealer spared the grater the marketability liquidity risk.For an investor who plans to hold the bond until the maturity date marketability/liquidity risk is less.

Wednesday, October 29, 2008


Yield Curve or Maturity Risk.
In many situations, a bond of a given maturity is used as an alternative to another bond of different maturity. An adjustment is to account for the differential interstate risks in the two bonds. However, this adjustment makes an assumption about how the interest rates (i.e.yields) at different maturities Will move. In the extent that the yield movements deviate form this assumption, there is yield-curve or maturity risk.
In general, yield-curve risk is more important is hedging situations rather than in pure investment decisions. for example, if a trader is hedging a position or if a pension fund or an insurance company is acquiring assets so as to unable it to meet a given liability, then yield-curve risk should be carefully examined. however, if a pension fund has decided to invest in the intermediate-term sector, then the fine distinctions in maturity are less important.
Another situation where yield-curve risk should be considered is in the analysis or bond swap transactions where the potential incremental returns are dependent entirely on the parallel shift (or other regularly arbitrary) as summation for the yield curve.


Credit Risk or Default Risk.
Credit or default risk,refers to the risk that the issuer of a fixed income security may default (i.e. The issuer will be unable to make timely principal and interest payment on the security).Credit risk is gauged by quality ratings assigned by commercial rating companies such as "Moody's Investor Service,Standard & Pooh's corporation,Duff & Phelps,McCray,Cris anti & Mafia,and Fitch Investors service,"as well as credit research staff of investment banking firms & institutional investor concerns.
Because of this risk, most bonds are sold at a lower price than or at a yield spared to comparable.US Treasury securities which are considered free of credit risk however except for the lowest credit securities (Known as "high-yield" or "Junk bonds" the investors is normally concerned more with the changes in the perceived credit risk &/or the cost associated with a given level of credit risk than with the actual vent of default.This is so because even though the actual default of an issuing corporation may be highly unlikely,the impact of the change on perceived credit risk or the spread demanded by the market for any given level of risk can have an immediate impact on the value of security.


Timing For Call Risk.
As explained in the previous post,many bonds contain a provision that allows the issuer to retire,or "call all or part of the issued before the maturity date".This issuer usually retains this right to refinance the bond in the future if market interest rates decline below the coupon rate.
From the investor's perspective,there are three disadvantages of the call provision.
  1. The cash flow pattern of the callable bond is not known with certainty.
  2. The issuer will call the bonds when interest rates have dropped.
  3. The capital appreciation potential of a bond will reduced because the price of a callable bond may not rise much above the price at which the issuer may call the bond.
Many long treasury and agency bonds,most corporate and municipal bonds,and almost all mortgage-backed securities have embedded in them the option on the part of the borrower to call,or terminate the bond before the stated maturity date.Even though the investor is usually compensated for talking the risk of call means of a lower price or a higher yield,it is not easy to determine of this compensation is sufficient.In any case,the returns from a bond with call risk can be dramatically different from those obtained from a non malleable bond.
The magnitude of this risk depends upon the various parameters of the call as well as on market conditions.Timing risk is so pervasive in fixed income portfolio management that many market participants consider it second only to interest rate risk in importance.
In the case of mortgage-backed securities,the cash flow depends or prepayments of principal made by the homeowners in the pool of mortgages that serves as collateral for the security. The timing risk in this case is called prepayment risk.It includes contraction risk-the risk that homeowners will prepay all or part of their mortgages when mortgages interest rates decline.If interest rates rise,however investors would benefit from prepayments.The risk that prepayments will fall down when mortgage interest rate is called extension risk.Thus,timing risk in the case of montage backed securities is called prepayment risk,which included contraction risk and extension risk.

Tuesday, October 28, 2008


Reinvestment Risk.
The cash flows received from a security are usually (or are assumed to be) reinvested.The additional income from such reinvestment, sometimes called interest on interest, depends on the prevailing interest rate levels at the time of reinvestment as well as on there reinvestment strategy.The variability in the returns from reinvestment from a given strategy due to changes in market rates in called reinvestment risk.
The risk here is that the interest rate at which interim cash flows can be reinvestment will fall.Reinvestment risk is greater for longer holding periods .It is also grater for securities with large,early cash flows such as high-coupon bonds.
It should be noted that interest rate risk and reinvestment risk opposite each other.For example interest rate risk is the risk that interest rates will rise,thereby reducing the price of a fixed income security.In contrast,reinvestment risk is the risk that interest rates will fall.A strategy heaved on these two offsetting risks is called "immunization".


Market or Interest rate risk.
The price of typical fixed income security moves in the opposite direction of the change in interest rates.As interest rate rice (pass),the price of a fixed income security will fall(rise).
For an investor who plans to hold fixed income security to maturity,the changes is its price before maturity is not of concern,however for an investor who may have to sell the fixed income security before the maturity date an increase in interest rates will mean the realization of a capital loss.This risk is referred to as market risk,or interest rate which is by far the biggest risk faceted by an investor in the fixed income market.
It is customary to represent the market by the yield levels on treasury securities.Most other yields are compared to the treasury levels and are quoted as spreads off appropriate treasury yields.To the extend that the yields of all fixed income securities are interrelated there prices respond to changes in treasury rates.
The actual magnitude of the price response for any security depends on various characteristics of the security such as coupon,maturity,and the options embedded into the security.


Risk associated with investing in fixed income securities.
The return obtained from a fixed income security from the day it is purchased to the day it is sold can be divided into two parts,
  1. The market value of the security when its even actually sold.
  2. the cash flows received from the security over the time period that it is held.Plus any additional income from reinvestment of the cash flow.
several environmental factors effect one or both of these two parts.We can define the risk in any security as a measure of these market factors on the return characteristics of the security.
The different types of risk that in fixed income securities is exposed to are as follows
  • Market or Interest-rate risk
  • Reinvestment risk
  • Timing or Call risk
  • Yield-curve maturity risk
  • Inflation or Purchasing power risk
  • Marketability or Liquidity risk
  • Exchange rate or Currency risk
  • Volatility risk
  • Political or Legal risk
  • Event risk
  • Sector risk
Each risk is describe in this stay with us.........................................................


Coding of costs.

CIMA defines a code as "a system of symbols designed to be applied to a classified set of items to give a brief accurate reference,facilitating entry,collation and analysis"
A cost cording system is therefore based on the selected cost classifications.It is provides a way of expressing the classification of each cost in a short ended symbolised form.

Composite codes
The CIMA terminology describes the use of composite symbols in codes.
For example-
symbol892.113 means
9-semi skilled
2-grade 2
1-indirect cost
1-east factory
3-finishing department

The advantages of a coding system

Some of the advantages of a well-designed coding system are as follows

  1. More suitable than a description in computerised system.
  2. A code reduces ambiguity.
  3. A code is usually briefer than description.
The requirements for an efficient coding system
  • Should be unique & certain.
  • Should be comprehensive & elastic.
  • should be as brief as possible.
  • To minimise errors.
  • The maintenance of the coding system should be centrally controlled.
  • All codes should be of the same length.(wherever possible)

Monday, October 27, 2008


List of International Accounting Standards

  • IAS 1- Presentation of Financial Statements
  • IAS 2- Inventories
  • IAS 3- Consolidated Financial Statements Originally issued 1976, effective 1 Jan 1977. Superseded in 1989 by IAS 27 and IAS 28.
  • IAS 4 - Depreciation Accounting Withdrawn in 1999, replaced by IAS 16, 22, and 38, all of which were issued or revised in 1998.
  • IAS 5 - Information to Be Disclosed in Financial Statements Originally issued October 1976, effective 1 January 1997. Superseded by IAS 1 in 1997.
  • IAS 6- Accounting Responses to Changing Prices Superseded by IAS 15, which was withdrawn December 2003
  • IAS 7 - Statement of Cash Flow
  • IAS 8 - Accounting Policies, Changes in Accounting Estimates and Errors
  • IAS 9 - Accounting for Research and Development Activities Superseded by IAS 38 effective 1.7.99
  • IAS 10- Events After the Reporting Period
  • IAS 11 - Construction Contracts
  • IAS 12- Income Taxes
  • IAS 13- Presentation of Current Assets and Current Liabilities Superseded by IAS 1.
  • IAS 14- Segment Reporting
  • IAS 15- Information Reflecting the Effects of Changing Prices Withdrawn December 2003
  • IAS 16- Property, Plant and Equipment
  • IAS 17- Leases
  • IAS 18- Revenue
  • IAS 19- Employee Benefits
  • IAS 20- Accounting for Government Grants and Disclosure of Government Assistance
  • IAS 21 - The Effects of Changes in Foreign Exchange Rates
  • IAS 22- Business Combinations Superseded by IFRS 3 effective 31 March 2004.
  • IAS 23- Borrowing Costs
  • IAS 24- Related Party Disclosures
  • IAS 25- Accounting for Investments Superseded by IAS 39 and IAS 40 effective 2001.
  • IAS 26- Accounting and Reporting by Retirement Benefit Plans
  • IAS 27- Consolidated and Separate Financial Statements
  • IAS 28- Investments in Associates
  • IAS 29- Financial Reporting in Hyperinflation Economies
  • IAS 30- Disclosures in the Financial Statements of Banks and Similar Financial Institutions Superseded by IFRS 7 effective 2007.
  • IAS 31- Interests In Joint Ventures
  • IAS 32- Financial Instruments: Presentation Disclosure provisions superseded by IFRS 7 effective 2007.
  • IAS 33- Earnings Per Share
  • IAS 34- Interim Financial Reporting
  • IAS 35- Discontinuing Operations Superseded by IFRS 5 effective 2005.
  • IAS 36- Impairment of Assets
  • IAS 37- Provisions, Contingent Liabilities and Contingent Assets
  • IAS 38 - Intangible Assets
  • IAS 39 - Financial Instruments: Recognition and Measurement
  • IAS 40- Investment Property
  • IAS 41 - Agriculture


International Financial Reporting Standards
International Financial Reporting Standards (IFRS) are standards and interpretations adopted by the International Accounting Standards Board (IASB).

Many of the standards forming part of IFRS are known by the older name of International Accounting Standards (IAS). IAS were issued between 1973 and 2001 by the board of the International Accounting Standards Committee (IASC). In April 2001 the IASB adopted all IAS and continued their development, calling the new standards IFRS.

Objective of financial statements

The framework states that the objective of financial statements is to provide information about the financial position, performance and changes in the financial position of an entity that is useful to a wide range of users in making economic decisions.

Underlying assumptions

The underlying assumptions used in IFRS are
  • Accrual basis - the effect of transactions and other events are recognised when they occur, not as cash is received or paid.
  • Going concern - the financial statements are prepared on the basis that an entity will continue in operation for the foreseeable future.
Qualitative characteristics of financial statements
The Framework describes the qualitative characteristics of financial statements as being

  • Understandability
  • Relevance
  • Reliability and
  • Comparability.
Elements of financial statements
The Framework sets out the statement of financial position (balance sheet) as comprising:-
  • Assets - resources controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity
  • Liabilities - a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits
  • Equity - the residual interest in the assets of the entity after deducting all its liabilities
    and the statement of comprehensive income (income statement) as comprising:
  • Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or reductions in liabilities.
  • Expenses are decreases in such economic benefits.
Recognition of elements of financial statements
n item is recognised in the financial statements when:-
  • it is probable that a future economic benefit will flow to or from an entity and
  • when the item has a cost or value that can be measured with reliability
Measurement of the Elements of Financial Statements
Measurement is how the responsible accountant determine the monetary values at which items are to be valued in the income statement and balance sheet. The basis of measurement has to be selected by the responsible accountant.
Accountants employ different measurement bases to different degrees and in varying combinations. They include, but are not limited to:

  • Historical cost
  • Current cost
  • Realisable (settlement) value
  • Present value
Concepts of Capital and Capital Maintenance
Concepts of Capital
financial concept of capital, e.g. invested money or invested purchasing power means capital is the net assets or equity of the entity.
A physical concept of capital means capital is the productive capacity of the entity.

Concepts of Capital Maintenance and the Determination of Profit
Accountants can choose to maintain financial capital in either nominal monetary units or constant purchasing power units.
Physical capital is maintained when productive capacity at the end is greater than at the start of the period.
The main difference between the two concepts is the way asset and liability price change effects are treated.
Profit is the excess after the capital at the start of the period has been maintained.
When accountants choose nominal monetary units, the profit is the increase in nominal capital.
When accountants choose units of constant purchasing power, the profit for the period is the increase in invested purchasing power. Only increases greater than the inflation rate are taken as profit. Increases up to the level of inflation maintain capital and is taken to equity.