Question

1. Evaluate the three major risks that bondholders face. Give Examples of Each.

2. Discuss the three factors that determine the Risk Structure of Interest Rates. Give Examples

3. Discuss the Four Theories that Explain the Term Structure of Interest Rates. Give the Key Assumptions of each theory.

Answer 1

(Question 1)

The major three risks faced by bondholders are:

(1) Interest rate risk

Since bond price and interest rate are inversely related, an increase in interest rate will decrease bond price. Lower bond price will cause a capital loss on holding the bond since its market price will fall.

(2) Credit risk (default risk)

A non-sovereign corporate bond always carry a risk of default which is the probability of the issuer defaulting on repayment (of interest and/or principal). Therefore except for government bonds such as T-bills, T-bonds or T-notes, yield on all bonds carry a default risk premium.

(3) Inflation risk

If inflation increases after purchase of a bond, real value of the coupon income and face value of bond decreases due to loss of purchasing power caused by inflation. Therefore, bondholder suffers a loss due to lower real value of the bond.

NOTE: As HOMEWORKLIB Answering Policy, 1st question is answered.