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.

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