Term
| 3 situations that make estimating bond cash flows difficult |
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Definition
1) principle repayment stream not certain b/c of puts, calls, prepayments, accelerated sinking fund provisions
2) coupon payments not certain b/c off inflation or with floating rate securities
3) bond is convertible or exchangeable into another security |
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Term
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Definition
| curved line showing higher prices = lower yields |
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Term
| arbitrage-free valuation approach |
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Definition
| discount each cash flow using a discount rate specific to the maturity of each cash flow |
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Term
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Definition
refers to the effect of changes in the prevailing market rate of interest on bond values.
Remember: when interest rates rise, bond prices fall. (inversely related)
The source of interest rate risk is approximated by the measure called "Duration." |
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Term
| Various Types of Risks in investing in Bonds |
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Definition
- Interest rate risk is the risk of capital loss due to an increase in interest rates.
- Yield curve risk is the uncertainty caused by shifts in the yield curve.
- Call risk is the risk the bond could be called away prior to maturity.
- Prepayment risk. If rates fall, causing prepayments to increase, an investor must reinvest these prepayments at the new lower rate.
- Reinvestment risk is the risk that the interim cash flows must be reinvested at a rate lower than anticipated.
- Credit risk is the risk that the issuer will fail to meet its obligations.
- Liquidity risk represents the likelihood that an investor will be unable to sell the security quickly and at a fair price.
- Exchange-rate risk is the uncertainty related to adverse exchange rate movements.
- Inflation risk is the chance that prices of goods/services will increase.
- Volatility risk is the affect on bond values with embedded options.
- Event risk encompasses the risks outside the risks of financial markets.
- Sovereign risk refers to changes in governmental attitudes and policies toward the repayment and servicing of debt.
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