Question

1. Demonstrate that bond yields and interest rates reflect the effect of six different things.

2. Define the real interest rate and five premiums that investors demand as compensation for risk.

3. Define each of these concepts: expected future inflation, interest rate risk, default risk, taxability and lack of liquidity.

4. Explain how each of these concepts influence investors: expected future inflation, interest rate risk, default risk, taxability and lack of liquidity.

(PLEASE DO NOT USE ANSWERS THAT HAVE ALREADY BEEN GIVEN).

Answer 1

Answer 1

Bond yields and interest rates reflect the effect of six different things namely-

a) Real interest rate-

b) 5 Premiums demanded by investors to compensate them for inflation

c) Interest Rate Risk

d) Default Risk

e) Taxability

f) Lack of Liquidity

Answer 2

Real Interest Rate- It is defined as the rate of interest which has been adjusted for inflation, It shows the change in the purchasing power .

It can be calculated using a simple formula-

Real rate of inflation = Nominal Rate of Inflation - Rate of inflation

Five premiums demanded by investors as compensation for risk-

Risk premium is the extra return an investor gets above the risk free rate for taking extra risk,

It has the following five compnents-

1) Business Risk - risk associated with company's inflows and outflows

2) Financial Risk- A company's ability to pay its debts

3) Liquidity Risk - The risk associated with uncertainty of an investment's cost and time

4) Exchange Rate Risk- The risk associated with a change in exchange of one currency with respect to the other

5) Country-specific risk - The risk associated with respect to a country's political,economic and social conditions

Answer 3

Expected future inflation-  Expected increase in the general level of prices over a given period of time

Interest Rate Risk- It is the risk to investments as a result of changes in interest rates. Can be reduced by having a diversified portfolio of investments,

Default Risk- It is the probability of that the individuals will default on their debt obligations

Taxability- It refers to the changes in the price of the securities because of the changes in the tax-exemption status

Lack of Liquidity-  It means low levels of cash/liquid assets to meet short term debt obligations

Answer 4

Expected future inflation- For people investing in fixed income securities expected rise in inflation is bad news because it reduces the value of their savings. For investors buying bonds and stocks inflation is not a big cause of worry as an anticipated increase in inflation also leads to an increase in the company's earnings in real terms in the long run.

Interest Rate Risk- When interest rates increase the opportunity cost of holding bonds increases as investors can now earn more by putting their money in a bank.

Default Risk- If the default risk is high the investors expect a higher rate of return on their investments. If a company defaults on its payments the investors may lose all their money.

Taxability- Taxes reduce the income earned by the investors. Investors should choose ELSS (Equity linked saving schemes) funds to save on taxes paid.

Lack of Liquidity-  Liquidity has an impact on the valuation of the company and it affects the share price. This is a direct concern for the investors as low liquidity will decrease the value of the company and is unfavourable for the investors.