Assume that someone asks you for some advice on investing in bonds. You are full
ID: 2654871 • Letter: A
Question
Assume that someone asks you for some advice on investing in bonds. You are fully aware of the five risk categories explained in Chapter 10. Assume that the person asking for advice would like to know your opinion on which risk is the one in which to be most cautious. Which risk is it and why? Furthermore, explain how an investor could potentially mitigate his risk. Support your position with examples from resources. Please provide reference and in cite quotes in response.
5 risk are:
Interest rate risk
purchasing power risk
business/financial risk
Liquidity risk
call risk
Explanation / Answer
Ans
The biggest risk in investin in bonds is the interest rate risk . Interest rate risk is the risk in the variability in the market price of Bonds. Interest rate is the biggest risk because of direct relationship between demand and supply of funds and interest rate. Interest rate and market price of a bonds are iinversely proportional.
Means of interest rate risk mitigation
1. Forward rate agreements -Where an investor can enter in to an agreement with a counter party to exchange the fixed rate interest streams calculated on notional principal with variable interest streams to hedge the variablity.
2. Another instrument for hedging is Interest rate swaps, which also involves the exchange of fixed rate streams with flexible rate streams.