DOCSLIB.ORG

Chapter 4 Interest Rate Measurement and Behavior Chapter 5 the Risk and Term Structure of Interest Rates

Total Page：16

File Type：pdf, Size：1020Kb

Download full-text PDF Read full-text
Chapter 4 Interest Rate Measurement and Behavior Chapter 5 the Risk and Term Structure of Interest Rates Chapter 4 Interest Rate Measurement and Behavior Chapter 5 The Risk and Term Structure of Interest Rates LEVEL OF INTEREST RATES Fisher Effect (risk-free rate) Interest rate has 2 components: (1) real rate (2) inflation premium I = r+ IP STRUCTURE OF INTEREST RATES http://www.ratecurve.com/yc2.html Term Structure of Interest Rates - defines the relationship between maturity & annualized yield, holding other factors such as risk, taxes, etc., constant. Graphic presentation is the yield curve. Curve shifts and twists through time. Four Basic Shapes: Positive Yield Curve: upward sloping Negative Yield Curve: downward sloping Flat Yield Curve Humped Yield Curve Level of Interest Rates: Loanable Funds Theory -- market interest rate is determined by the factors that control the supply of and demand for loanable funds. Demand Factors Household: Y increases then installment debt increases R increases then installment debt falls Business: n CFt NPV = - I + å (1+i )t T =1 if i decrease _ NPV (?) Government: interest inelastic 1980: debt/GNP =25% 1987: debt/GNP=42% Foreign Foreign interest rates vs. U.S. rates Supply Households - largest suppliers Very steep slope for supply. Why? What happens if expect higher inflation? Savers - Liquidity Preference Theory - Market rate of interest is determined by demand/supply of money balances. Demand of Money + Transaction f(y) + Precautionary f(y) - Speculative f(r) Supply of Money Fed basically determines supply Few uncontrollable factors (1) banks lending (2) public's preference for cash Letting D=S then solve for interest rate: + + - _ r = f ( , , ) y m p e THEORIES ON SHAPE OF YIELD CURVE Unbiased Expectations - shape of yield curve is determined solely by current & expected future short-term interest rates. A 2 year security should offer a return that is similar to the anticipated return from investing in 2 consecutive one-year securities. 2 (1+t R2 ) = (1+t R1 )(1+t+1 r1 ) 3 (1+t R3 ) = (1+t R1 )(1+t+1 r1 )(1+t+2 r1 ) t+1r1 / one year interest rate that is anticipated as of time t+1. t+2r1 / one year interest rate that is anticipated as of time t+2. R1 } R2 } Known annualized rate on 1 year security, 2 year security, 3 year security. R3 } Eg. .t R2 = .10 .t R1 = .08 if 2 (1+.1 ) = (1.08)(1+t+1r1 ) (1.1 )2 .t+1r1 = - 1 @ .12 1.08 then Expect interest rates to rise: investor (saver) wants s-t security borrowers want L-T security Borrowers are the suppliers of securities (IOU's) therefore s-t demand > supply then increase in Price which results in a decrease in yield and we have an upward sloping curve. Risk neutral Liquidity Premium Investor becomes risk averse prefer s-t security over L-T security. Inducement to buy L-T must add premium. Segmented Markets Unlike first 2 theories which treat market as a whole - this theory treats market as if made up of segments. Investors/borrowers choose security with maturities that satisfy their forecasted cash needs. Therefore, need rather than expectations of s-t rates determine where a person invests. Demand/Supply within segments drive rates. ¦ rate¦ ¦ Upward ¦ Pension Life Ins. ¦ Thrifts ¦ ¦ Bank +---------------------------------------------- Time ¦ ¦ ¦ ¦ Downward ¦ Bank ¦ Thrifts ¦ Pension ¦ +---------------------------------------------- Demand for L-T increases or D>S for S-T Prices increases for L-T and yield for L-T decreases Preferred Habitat Combines Expectations & Segmented Investors may have a preferred investment horizon (habitat) but their expectations on int. rates move them within or even out of their habitat. Which Theory is Correct? Research by Meiselman on interest rate expectations found they strongly influence on the term structure-- they have looked at how accurate forward rates are--not very accurate--therefore other factors also influence interest rates Kessel found that liquidity premium caused forward rates to have a positive bias Other research on liquidity premium have found that the size of the premium varies inversely with interest rate levels and yet others have found the opposite to be true Elliot and Echols have examined the segmented market idea--they found discontinuities in the yield maturity relationship--may be due to supply and demand of segments All of the theories have some evidence on their validity Integrating the theories Example: 1. Borrowers and investors expect rates to rise they invest (expectation theory) 2. Borrowers need long term funds while investors prefer short-term (segmentation theory) 3. Investors prefer more liquidity than less (liquidity premium theory) In this example, all theories suggest an upward sloping curve ---domination of the views would determine the slope--ie. If #1 was dominate but the expectation was for declining rates then might have a slightly downward sloping curve Other factors that affect yield on Sec. (1) Default risk (2) Liquidity (3) Tax Status (4) Term-to-Maturity (5) Special Provisions Call Convertibility Yield on Sec r = R/ + DP + LP + Special Provision INTEREST RATES/BOND PRICES Appropriate price of a sec. is the PV of remaining cash flows PV considers (1) size of cash flow (2) timing of cash flow (3) required rate of interest. which includes adj. for risk m Ct Price of Bond = å (1+i )t t =1 Two Cash Streams Annuity (interest) i 1-(1+ )-nm = A [ m ] PV a i m Single Sum S PV s = i (1+ )nm m Semiannually therefore need to adjust interest rate and period. As interest rates rise, bond prices lower, but this is not 1-1 relationship. Coupon Rate - YTM Relationship Coupon Rate > YTM Y sell at premium Coupon Rate < YTM Y sell at discount Coupon Rate = YTM Y sell at par or face value Coupon Rate = Interest in dollars Par Value Current Yield = Interest in dollars Price of Bond YTM= Capital gain (loss) + income from interest payments YTM (Exact) C1 C2 Cm +Par Bond Price = + +....+ (1+YTM )1 (1+YTM )2 (1+YTM )m Solve for YTM YTM (approximate) Par - Price Annual Interest dollars + number of yrs maturity = YTM app Price + Par 2 YTM (Exact) C1 C2 Cm +Par Bond Price = + +....+ (1+YTM )1 (1+YTM )2 (1+YTM )m Solve for YTC Rate Maturity Bid Ask Bid Chg Yld 81/4s 2000-05* May 105:25 106:1 +4 7.53* * May 2000-05 Bond matures on 2005 but is callable starting in 2000 ** Yld For callable bonds the YTM is calculated in one of two ways a. to first call date when the asked price is above par b. to maturity date when the asked price is equal to or below par YTC 1. Substitute the Call Price for Par 2. Substitute the number of years to first call for maturity years Effective Yields: r mn Realized Yield =(1+ ) - 1 m Continuous Compounding = er - 1 e . 2.7183 Point of interest: Difference between nominal rate and add-on and discount. Add-On 36 months, r = 10% $5000 borrowed monthly payment: Interest Payment: 1) 5000 x .10 x 3 = $1500 2) (5000 + 1500)/36 = 180.56 Actual Interest Rate 5000 = 180.56 [PVIFA x ,36] 27.69 = x x = 1.5%/month Y Annual 18% Discount 36 months Interest $1500 Pay $5000 Receive $3500 Payment 5000 = $138.9 36 3500 = 138.9 (PVIFA x, 36) 25.2 = x x = 2%/month 24% Annual Valuation of Zero Coupoin Securities: Price = Maturity Value ( PVIF % , n) If the security is sold on a discount then the price is equal to the PV of a lump sum. Money market instruments sold on a discount basis are sensitive to changes in interest rates but not to the same degree as bonds with coupon payments. 360 100- P Discount Yield = [ ] n 100 Treasury Bill Yields 365 100 - P Equivalent Yield = [ ] n P i.e. Discount yield on bill 8.6% with 80 days till maturity. 360 100- Price .086 = 80 100 8.6 = 4.5 [ 100 - Price ] 4.5 [Price] = 447.4 P = 98.48 365 100- Price .086 = 80 Price Equivalent Yield = 8.6% .0188 = 100 - Price Price 1.0188 [Price] = 100 Price = 98.15 Factors Affecting Bond Prices Strong economic growth tends to place upward pressure on interest rates Weak economic growth tends to place downward pressure on interest rates Money supply increase (demand not affected) downward pressure on rates Money supply increase ( demand increases for funds) upward pressure--inflation Oil prices have major impact upon prices drop in oil prices--lower interest rates Weaker dollar ( everything else constant) increase inflationary expectations ( prices of imports increase); thus increase in rates Default risk Exchange Rates and Foreign Bonds Risk that currency will depreciate and more than offset any coupon rate advantage when the interest payments are converted into US dollars International Diversification Reduce exchange rate risk by diversifying among foreign securities denominated in various foreign currencies. Diversify internationally to reduce exposure to interest rate risk and default risk. By investing in many countries avoid only one country=s economy and interest rates to affect the bond portfolio. Duration Measurement of timing of Cash Flows (1) Term to Maturity - Number of years to final payment - Ignores interim cash flows - Ignores Time Value (2) Weighted Average Term to Maturity - Computes the proportion of each individual payment as a percentage of all payments and makes this proportion the weight for the year the payment is made. CF1 CF 2 CFm WATM = (1) + (2) + ... + (m) TCF TCF TCF Cft = the cash flow in year t m = maturity TCF = Total Cash Flow e.g. 10 year 4% bond TCF = 1400 40 40 40 40 1040 WATM = + (2) + (3) + ... + (9) + (10) = 8.71 yrs 1400 1400 1400 1400 1400 - Considers timing of all cash flow - Does not consider time value of the flows DURATION Duration: Weighted Average number of years until an initial cash investment is recovered with the wight expressed as the relative present value of each payment of interest and principle.
Load more

Recommended publications
  • Assessing Securities Lending Risk-Return Performance in a Portfolio Context
    Asset-Based Lending Assessing Securities Lending Risk-Return Performance in a Portfolio Context by Ben Atkins and Glenn Horner hile many institutional investors embrace paying a rebate rate on this cash collateral.1 Demand securities lending as an attractive tool to to borrow securities usually causes the rebate rate to enhance portfolio returns, others remain wary. fall below the risk-free rate (the line). For some secu- WMany perceive securities lending to be an eso- rities, this spread is quite substantial; the demand teric distraction—a tool limited by risky, immaterial spread represents the “specialness” of a security to returns. State Street addresses the latter view by borrowers. Some lenders are content with the grounding investors’ performance analysis on risk- demand spread; they simply invest the cash collateral adjusted returns. The data lead to two key conclu- in Treasury repo. Most lenders, however, seek addi- sions for investment managers and plan sponsors: tional returns by investing the collateral in high-qual- 1. Although securities lending returns are relative- ity money market instruments (collateral reinvest- ly small, superior risk-adjusted performance ment).2 In this way, they capture reinvestment highlights its value. returns by assuming a limited degree of credit and 2. Managers may optimize their lending program through a broader framework that integrates the Figure 1 risk-return performance of the underlying Disaggregation of Securities Lending Returns investments. Increasingly, investors focus on minimizing Reinvestment return “frictional” losses due to management fees, commis- sions, and inefficient trading. A well-structured lend- Reinvestment spread ing program represents an attractive tool to offset Risk-free rate some of these losses.
    [Show full text]
  • Understanding and Managing Risk in Public Investing
    CDIAC/CMTA Advanced Public Funds Investing Workshop Session Three: Understanding and Managing Risk in Public Investing Presented by: Sarah Meacham, Managing Director January 15, 2020 PFM Asset 601 S. Figueroa Street, Suite 4500 Management LLC Los Angeles, CA 90017 www.pfm.com 213.489.4075 © PFM 1 TYPES OF FIXED INCOME INVESTMENT RISK Inflation Interest rate Topics Liquidity Reinvestment Credit HOW TO MANAGE AND MITIGATE RISK Investment policy development Diversification Discipline to long-term strategy Performance measurement © PFM 2 “Risk is inherent throughout the investment process. There is investment risk associated with any investment activity and opportunity risk related to inactivity.” ~Local Agency Investment Guidelines, CDIAC January 1, 2019 © PFM 3 Types of Fixed Income Investment Risk © PFM 4 Types of Fixed Income Investment Risk Inflation Risk Liquidity Risk Credit Risk Loss of purchasing Inability to sell portfolio Risk of default or power over time as a holdings at a competitive decline in security value result of inflation price due to issuer’s financial strength Reinvestment Risk Interest Rate Risk The risk that a security’s Variability of return/price cash flow will be related to changes in reinvested at a lower interest rates rate of return © PFM 5 Inflation Risk © PFM 6 Inflation (Purchasing Power) Risk Loss of purchasing power over time as a result of inflation Real interest rate is after inflation; nominal is before inflation • Real = nominal – inflation • Nominal = real + inflation • Inflation = nominal
    [Show full text]
  • Property/Liability Insurance Risk Management and Securitization
    PROPERTY/LIABILITY INSURANCE RISK MANAGEMENT AND SECURITIZATION Biography Trent R. Vaughn, FCAS, MAAA, is Vice President of Actuarial/Pricing at GRE Insurance Group in Keene, NH. Mr. Vaughn is a 1990 graduate of Central College in Pella, Iowa. He is also the author of a recent Proceedings paper and has been a member of the CAS Examination Committee since 1996. Acknowledgments The author would like to thank an anonymous reviewer from the CAS Continuing Education Committee for his or her helpful comments. PROPERTY/LIABILITY INSURANCE RISK MANAGEMENT AND SECURITIZATION Abstract This paper presents a comprehensive framework for property/liability insurance risk management and securitization. Section 2 presents a rationale for P/L insurance risk management. Sections 3 through 6 describe and evaluate the four categories of P/L insurance risk management techniques: (1) maintaining internal capital within the organization, (2) managing asset risk, (3) managing underwriting risk, and (4) managing the covariance between asset and liability returns. Securitization is specifically discussed as a potential method of managing underwriting risk. Lastly, Section 7 outlines four key guidelines for cost- effective risk management. 1. INTRODUCTION In recent years, the property-liability insurance industry has witnessed intense competition from alternative risk management techniques, such as large deductibles and retentions, risk retention groups, and captive insurance companies. Moreover, the next decade promises to bring additional competition from new players in the P/L insurance industry, including commercial banks and securities firms. In order to survive in this competitive new landscape, P/L insurers must manage total risk in a cost-efficient manner. This paper provides a rationale for P/L insurance risk management, then describes four categories of risk management techniques utilized by insurers.
    [Show full text]
  • Diversification and Discussion of Risk
    Diversification and Discussion of Risk Conference of the County Investment Academy San Antonio June 2019 PFIA 2256.008c Requires Training in: • Investment Diversification 2 Capital Market Theory 12.0% 10.0% 8.0% E( r) 6.0% P* * 4.0% 2.0% 0.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% Std. Dev. 3 Capital Market Theory • Points along the upper half of the curve represent the best risk/return diversified portfolios of risky assets • The straight line represents portfolios obtained by investing in the “optimal risky portfolio” (P*) and either lending or leveraging at the “risk‐free” rate. • Points on the line below the curve represent “lending” and points above represent “leveraging” (note increased “risk” as measured by standard deviation of returns!) 4 So in theory….. Key result? An undiversified portfolio yields inferior return for the level of risk! The same, or higher, return could be attained at a lower level of risk with a diversified portfolio. If you are not diversified, you are taking more risk than you can expect to be compensated for! 5 Diversification and Correlation of Returns Correlation, which measures the degree of “co‐ movement”, ranges from ‐1 to +1. When the correlation between returns is less than 1 there are diversification benefits—the risk of portfolio is less than the average of the risks of the individual assets. Which pair of stock returns is more correlated? Chevron, Exxon Chevron, Delta Airlines 6 International Diversification Correlations vs S&P 500: China 0.62 Korea 0.53 Japan 0.73 Germany 0.74 UK 0.73 Brazil 0.29 Chile 0.38 Monthly returns vs corresponding MSCI indexes (US dollar returns) 5 years ended April 2019 Source: FactSet 7 Global Market Capitalization Latin Canada 1% UK 3% Other 5% 1% Japan 8% Asia ex Japan 13% U.S.
    [Show full text]
  • Securities Loans Collateralized by Cash: Reinvestment Risk, Run Risk
    Securities Loans Collateralized by Cash: Reinvestment Risk, Run Risk, and Incentive Issues Frank M. Keane Securities loans collateralized by cash are by far the most popular form of securities-lending transaction. But when the www.newyorkfed.org/research/current_issues F cash collateral associated with these transactions is actively reinvested by a lender’s agent, potential risks emerge. This 2013 F study argues that the standard compensation scheme for securities-lending agents, which typically provides for agents to share in gains but not losses, creates incentives for them to take excessive risk. It also highlights the need for greater scrutiny and understanding of cash reinvestment practices— especially in light of the AIG experience, which showed that Volume 19, Number 3 Volume risks related to cash reinvestment, by even a single participant, could have destabilizing effects. lthough less researched than the money markets, the collateral markets IN ECONOMICS AND FINANCE are critical to the efficiency of the asset markets—including the markets for ATreasury, agency, and agency mortgage-backed securities. Well-functioning collateral markets allow dealers and investors in the asset markets to finance short positions for the purposes of hedging, market making, settlement, and arbitrage. Two important mechanisms for accessing the U.S. money and collateral markets are repurchase agreements (repos) and securities-lending transactions. In a money market transaction, when cash and securities are exchanged, the securities act as collateral and mitigate the risks associated with a borrower’s failure to repay the cash. In a collateral market transaction, however, the cash serves as collateral and mitigates the risk associated with replacing the security if the borrower fails to return it.
    [Show full text]
  • Interest Rate Risk • Interest Rate Risk Is the Risk Market Rates Will Change. O
    MANAGING BOND PORTFOLIOS Interest Rate Risk Interest rate risk is the risk market rates will change. o Price risk—bond prices (values) move opposite interest rates; there exists an inverse relationship such that prices decrease when market rates increase, and vice versa. o Reinvestment risk—interest rate changes are positively related to the ability to reinvest at favorable rates; that is, when market rates increase, the coupon interest that is paid by a bond can be reinvested at higher rates, and vice versa. Interest rate sensitivity—the characteristics of bonds indicate how sensitive bond prices are to changes in interest rates. o Bond prices move opposite changes in interest rates (inversely related). When market yields increase, bond price decrease, and vice versa. A price decrease that results from an increase in the market rate will be less than a price increase that results from an equivalent decrease in the market rate. o Everything else equal, bond prices are more sensitive for bonds with: . Longer terms to maturity than bonds with shorter terms to maturity. The sensitivity of longer-term bonds increases at a decreasing rate, which means that a bond with 20 years to maturity is not twice as sensitive to changes in market rates than a bond with 10 years to maturity; e.g., the price of a 10-year bond might decrease by 6 percent when market rates increase, whereas the price of the 20- year bond would decrease by 9 percent for the same change in market rates. Bonds with lower coupon rates than bonds with higher coupon rates.
    [Show full text]
  • Blackrock Securities Lending
    BlackRock Securities Lending Unlocking the potential of portfolios January 2021 | Securities Lending Introduction: In summary: Securities lending is a well-established practice whereby • While not without risk, securities lending seeks to U.S. registered funds, such as mutual funds, make loans benefit the fund. of securities to seek an incremental increase in returns for • BlackRock has focused on delivering competitive fund shareholders. returns while balancing return, risk and cost in its three This paper explains the basics of securities lending, decades of lending securities on behalf of outlines the benefits and risks for investors, and describes shareholders. BlackRock’s leading approach to securities lending. • Since 1981, BlackRock has delivered positive monthly lending income for every fund that has participated in Basics of Securities Lending securities lending, including mutual funds. In securities lending transactions, mutual funds lend stocks or bonds to generate additional returns for Benefits of Securities Lending the funds. Mutual fund investors can benefit from securities lending Here’s how it works: first, a large financial institution asks in the form of fund performance. How? The mutual fund to borrow a stock or bond from a mutual fund. In order to seeks to generate additional income through the rate that borrow the stock or bond, the financial institution will it charges for lending securities (if applicable), and/or income on the reinvestment of the collateral that the negotiate financial terms with the lending agent of the borrower provides in exchange for the loan. mutual fund and provide collateral. The mutual fund keeps the collateral to secure repayment in case the Securities lending returns typically vary by asset class and borrower fails to return the loaned stock or bond.
    [Show full text]
  • Asset Securitisation
    Superseded document Basel Committee on Banking Supervision Consultative Document Asset Securitisation Supporting Document to the New Basel Capital Accord Issued for comment by 31 May 2001 January 2001 Superseded document Superseded document Table of Contents OVERVIEW .............................................................................................................................................1 I. THE TREATMENT OF EXPLICIT RISKS ASSOCIATED WITH TRADITIONAL SECURITISATION........................................................................................................................1 A. THE STANDARDISED APPROACH .............................................................................................2 1. The treatment for originating banks..........................................................................2 (a) Minimum operational requirements for achieving a clean break.................................3 (b) Minimum capital requirements for credit enhancements ............................................3 (c) Minimum operational requirements for revolving securitisations with early amortisation features .............................................................................................................4 2. The treatment for investing banks ............................................................................6 (a) Minimum capital requirements for investments in ABS...............................................6 (b) Treatment of unrated securitisations ..........................................................................7
    [Show full text]
  • Reviewing Systemic Risk Within the Insurance Industry
    Reviewing Systemic Risk within the Insurance Industry February 2017 2 Reviewing Systemic Risk within the Insurance Industry SPONSOR Society of Actuaries AUTHOR Max J. Rudolph, FSA, CERA, CFA, MAAA Caveat and Disclaimer The opinions expressed and conclusions reached by the authors are their own and do not represent any official position or opinion of the Society of Actuaries or its members. The Society of Actuaries makes no representation or warranty to the accuracy of the information. Copyright ©2017 All rights reserved by the Society of Actuaries © 2017 Society of Actuaries 3 TABLE OF CONTENTS Executive Summary .................................................................................................................................................. 4 Systemic Risk ............................................................................................................................................................ 5 Systemic Risk Definition ............................................................................................................................................. 5 Definition Nuances ..................................................................................................................................................... 7 What are the Drivers of Systemic Risk? ................................................................................................................... 10 Size ..............................................................................................................................................................
    [Show full text]
  • Interest Rate Risk # Reinvestment Risk: the Returns on Funds to Be Reinvested Will Fall Below the Cost of Funds
    Interest Rate Risk # Reinvestment risk: the returns on funds to be reinvested will fall below the cost of funds. # Refinancing risk: the costs of rolling over funds or reborrowing funds will rise above the returns generated on investments. # Int rate risk is the risk incurred by an FI if it mismatches the maturities of it’s A & L. # Market value risk: Interest rate increase, the market value of assets and liabilities decrease Credit risk is é possibility that promised cash flows may not occur or may only partially occur. 2 types of credit risk: 1. Systematic credit risk affects all borrowers. 2. Firm-specific credit risk affects a particular company. NB:Firm-specific credit risk can be managed through diversification. (b) Which types of FIs are more susceptible to this type of risk? Why? Answer: FIs that lend money for long periods of time, whether as loans or by buying bonds, are more susceptible to this risk than those FIs that have short investment horizons. ‐ Maturity Model •MA–ML > 0: the FI is exposed to increasing interest rates. R asset decrease more •MA– ML < 0: the FI is exposed to decreasing interest rates. R liability decrease more •MA– ML = 0: the FI is ‘immunised’. For most FIs: MA– ML > 0. Maturity matching does not always eliminate interest rate risk exposure, because: a. The duration of A & L might be different, b. The maturity model does not consider the leverage of the FI ‐ Duration Model Duration and maturity: dD/dM>0 Duration and yield: dD/dR< 0 Duration and coupon interest rate: dD/dC< 0 Foreign Exchange Risk Foreign exchange risk: The risk that changes in exchange rates can affect the value of an FI’s Asset and/or Liabilities located abroad.
    [Show full text]
  • Investment Risk: What Risks Are You Willing to Take? Compound Value Advisers by Jerry Matecun
    Investment Risk: What Risks Are You Willing to Take? Compound Value Advisers by Jerry Matecun Stocks For the Long-Term….What About Your Term? The first reaction to the chart below is – a no-brainer – stocks compound at a much higher rate than bonds and inflation; therefore, put your money in stocks for the long-term! Yet we know that in the last 15 years we have seen two investment booms that went bust in a very short time period. Stocks declined over 50% in 18 months; there have been several longer term stock declines throughout history. Statistical certainty of future returns does not exist, and this presents a challenge to managing portfolio risk. Time horizon is a key element to consider. A younger person with a long time horizon can better handle this type of market risk. However, as you near retirement age, this kind of decline can cause very real anxiety. Understanding the relationship between the various risk and rates of return inherent in every asset class is fundamental to constructing an investment plan that can help you sleep at night. Ibbotson® SBBI® Stocks, Bonds, Bills, and Inflation 1926–2012 $18,365 $10,000 $3,533 Compound annual return 1,000 • Small stocks 11.9 % • Large stocks 9.8 • Government bonds 5.7 • Treasury bills 3.5 • Inflation 3.0 $123 100 $21 $13 10 1 0.10 1926 1936 1946 1956 1966 1976 1986 1996 2006 Past performance is no guarantee of future results. Hypothetical value of $1 invested at the beginning of 1926. Assumes reinvestment of income and no transaction costs or taxes.
    [Show full text]
  • Financial Instruments Risks
    Financial Instruments Risks Market Risk Market Risk, also known as “undiversifiable risk,” “volatility” or “systematic risk,” affects the overall market or a broad sector, not just a particular financial instrument or company, and it cannot be mitigated through diversification. It is the risk of an adverse change of price of a portfolio or an asset as a result of changes in the entire market or an entire market segment. Credit Risk The risk of loss of principal or loss of a financial reward stemming from an issuer’s failure to repay any type of debt, or meet a contractual obligation. In bond markets credit risk relates to: (a) the price fall due to increased credit risk of the issuer (increased credit spreads, decreased credit ratings, etc), (b) the risk that the issuer will not fulfill its obligations, such as coupon and principal payment for any reason, including bankruptcy or other insolvency proceedings. This risk is higher in the emerging markets and in securities with low credit rating (below investment grade). Interest rate risk Refers to changes in the yield of an investment due to interest rate fluctuations. A shift in the yield curve would result in a change in a bond’s price. If the level of yields / yield curve is higher than it was at the time of initial investment, early liquidation in these securities will be realized at a price lower than the price of the initial investment. This risk is higher in emerging markets and in high yield bonds. Liquidity Risk The risk that a given security or asset cannot be traded quickly enough in the market, due to the lack of marketability to prevent or minimize a loss (or make the required profit).
    [Show full text]