Risks Associated with Investing in Bonds by Frank J. Fabozzi,Copyright 2007 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express permission of the copyright owner is unlawful. Request for futher information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.,PowerPoint Slides by David S. Krause, Ph.D., Marquette University,Chapter 2 - Risks Associated with Investing in Bonds,Major learning outcomes: Understand the various risks associated with investing in bonds: Interest rate Call and prepayment Yield curve Reinvestment Credit Liquidity Exchange-rate Inflation Volatility Event Sovereign,Key Learning Outcomes,Explain the various risks associated with investing in bonds (e.g., interest rate risk, call and prepayment risk, yield curve risk, reinvestment risk, credit risk, liquidity risk, exchange-rate risk, inflation risk, volatility risk, and event risk).Explain why there is an inverse relationship between changes in interest rates and bond prices.Identify the relationships among a bonds coupon rate, yield required by the market, and price relative to par value (i.e., discount, premium, or par value).Explain how features of a bond (maturity, coupon, and embedded options) affect its interest rate risk.Identify the relationship among the price of a callable bond, the price of an option-free bond, and the price of the embedded call option.Explain how the yield level impacts the interest rate risk of a bond.Explain the interest rate risk of a floating-rate security and why its price may differ from par value.,Key Learning Outcomes,Compute the duration of a bond given its price changes when interest rates change.Interpret the meaning of the duration of a bond.Use duration to approximate the percentage price change of a bond and calculate the new price if interest rates change.Explain yield curve risk and explain why duration does not account for yield curve risk for a portfolio of bonds.Explain key rate duration.Identify the factors that affect the reinvestment risk of a security.Explain the disadvantages of a callable and prepayable security to an investor.Explain why prepayable amortizing securities expose investors to greater reinvestment risk than nonamortizing securities.Describe the types of credit risk: default risk, credit spread risk, and downgrade risk.,Key Learning Outcomes,Explain a rating transition matrix.Distinguish between investment grade bonds and noninvestment grade bonds.Explain what a rating agency does and what is meant by a rating upgrade and a rating downgrade.Explain why liquidity risk is important to investors even if they expect to hold a security to the maturity date.Describe the exchange rate risk an investor faces when a bond makes payments in a foreign currency.Explain inflation risk.Explain yield volatility, how it affects the price of a bond with an embedded option, and how changes in volatility affect the value of a callable bond and a putable bond.Describe the various forms of event risk.Describe the components of sovereign risk.,Interest Rate Risk,Bond prices and interest rates move in opposite directions.Since the price of a bond fluctuates with market interest rates, the risk faced by investors is that the price of a bond will fall if rates rise.This is referred to as interest rate risk which is the major risk faced by bondholders.,Bond Prices and Interest Rates,Bond PricePr Yield,Longer term bonds are more sensitive to changes in interest rates than shorter term bonds.,Inverse, non-linear shape,Interest Rate Risk,Key relationships: a bonds coupon rate the yield required by the market the bonds price relative to par value (i.e., discount, premium, or equal to par)Because an investor cannot force the issuer to change the coupon rate or the time to maturity, it is the price that will change relative to movements in market interest rates.,Interest Rate Risk,Bond valuation basics: A bond will trade at a price equal to par when the coupon rate is equal to the yield required by the market.A bond will trade at a discount (price below par) when the coupon rate is below the yield required by the market.A bond will trade at a premium (price above par) when the coupon rate is above the yield required by the market.If market interest rates increase (decrease), the price of a bond will decrease (increase).,Features Impacting Interest Rate Risk,The features of a bond that affect interest rate risk: Maturity Coupon rate Embedded optionsA bonds price sensitivity to changes in market interest rates depends on these key features which are unique to each bond issue.,