Showing posts with label risks. Show all posts
Showing posts with label risks. Show all posts
Wednesday, 28 July 2010
Legal documentation for reducing settlement failures
There have been several attempts by regulatory bodies within the financial industry to reduce settlement failures. One of the methods put forward was to create more generic documentation structures. For some markets, where each deal is unique, this can be extremely difficult. Eg. consider the case of documentation of OTC derivatives.
Standard documentation of OTC derivatives
In the over-the-counter (OTC) market, each deal is negotiated between two parties depending on their particular circumstances. Asking both parties to use some form of generic documentation to record the deal can be unworkable especially if the details of their deal are unusual.
The International Swaps and Derivatives Association (ISDA) and the British Bankers’ Association (BBA) are two regulatory bodies that developed standard documentation for OTC derivatives.
There are now master agreement forms for many financial products that create a common legal framework that can be understood by all market participants. These master agreements cover most, if not all, of the major legal points that should be agreed as part of documenting the transactions to which they relate.
Master agreements cover how the parties will conduct themselves in the event of the early termination of the contractual agreements because of credit default or other unforeseen events. In particular, the agreements specify how the exposures for more than one transaction under the master agreement will be netted against each other if one or more transactions have positive exposure and other transactions have negative exposure.
In addition to the master agreements, individual transactions are tied to the master agreements with confirmation documents containing the specific terms of each transaction. The master agreements should ideally be negotiated prior to any individual transaction being agreed but, in many cases, they are only negotiated as a consequence of the first transaction.
The International Swaps and Derivatives Association (ISDA) and the British Bankers’ Association (BBA) are two regulatory bodies that developed standard documentation for OTC derivatives.
There are now master agreement forms for many financial products that create a common legal framework that can be understood by all market participants. These master agreements cover most, if not all, of the major legal points that should be agreed as part of documenting the transactions to which they relate.
Master agreements cover how the parties will conduct themselves in the event of the early termination of the contractual agreements because of credit default or other unforeseen events. In particular, the agreements specify how the exposures for more than one transaction under the master agreement will be netted against each other if one or more transactions have positive exposure and other transactions have negative exposure.
In addition to the master agreements, individual transactions are tied to the master agreements with confirmation documents containing the specific terms of each transaction. The master agreements should ideally be negotiated prior to any individual transaction being agreed but, in many cases, they are only negotiated as a consequence of the first transaction.
Operational Risk
Operational risk was initially defined in the negative as any form of risk that is not market or credit risk. This negative definition is rather vague as it does not tell us much about the exact types of operational risks faced by banks today, nor does it provide banks with a proper basis for measuring risk and calculating capital requirements.
A better definition is provided by the Basel Committee, who define operational risk as:
"The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events."
This definition includes legal risk, but excludes strategic and reputational risk. However, because operational risk is a term that has a variety of meanings, banks are permitted to adopt their own definitions, provided the minimum elements in the Committee's definition are included.
Operations Risk Vs. Operational Risk
There exists an important distinction between operations risk and operational risk.
Operations risk relates to the activities carried out by the operations or back office department of a bank. The back office is the area of a bank that looks after most of the administrative side of any trades undertaken by the front office. It is therefore responsible for the accurate and timely settlement of all transactions in accordance with trade deadlines.
Operational risk is a much broader concept incorporating not just the activities of back office departments, but also many other possible risk events across the whole organization. In its 2003 paper on 'Sound Practices for the Management and Supervision of Operational Risk', the Basel Committee (in conjunction with the banking industry) identified seven loss event categories that can potentially result in substantial operational losses.
1. Internal fraud
2. External fraud
3. Employment practices and workplace safety
4. Clients, products, and business practices
5. Damage to physical assets
6. Business disruption and system failures
7. Execution, delivery, and process management
A better definition is provided by the Basel Committee, who define operational risk as:
"The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events."
This definition includes legal risk, but excludes strategic and reputational risk. However, because operational risk is a term that has a variety of meanings, banks are permitted to adopt their own definitions, provided the minimum elements in the Committee's definition are included.
Operations Risk Vs. Operational Risk
There exists an important distinction between operations risk and operational risk.
Operations risk relates to the activities carried out by the operations or back office department of a bank. The back office is the area of a bank that looks after most of the administrative side of any trades undertaken by the front office. It is therefore responsible for the accurate and timely settlement of all transactions in accordance with trade deadlines.
Operational risk is a much broader concept incorporating not just the activities of back office departments, but also many other possible risk events across the whole organization. In its 2003 paper on 'Sound Practices for the Management and Supervision of Operational Risk', the Basel Committee (in conjunction with the banking industry) identified seven loss event categories that can potentially result in substantial operational losses.
1. Internal fraud
2. External fraud
3. Employment practices and workplace safety
4. Clients, products, and business practices
5. Damage to physical assets
6. Business disruption and system failures
7. Execution, delivery, and process management
Saturday, 17 July 2010
Laddering
Laddering is an effective investment technique that is used by many intelligent investors who want to put their money to best possible use. You can do a Ladder using many investment options like Bank FD, NSC Certificates, Bonds etc.
Just like a normal ladder, our investment ladder also has a certain number of steps. This is determined by the initial number of investments that we would be ready to make. Let us take an example where a Bank FD ladder is formed by Mr. X.
Let us say Mr. X has idle cash of Rs. 3 lakhs and is willing to deposit it in a bank to ensure safety of the capital. Let us say the bank offers him an interest of 8% for one year and Mr. X invests it happily. At the end of the first year Mr. X would get Rs. 24,000/- as interest. Now if Mr. X wants to invest in the bank FD again, there is no guarantee that the bank would offer 8% or more. Based on the market interest rates, the bank may opt to reduce it. Let us say the bank reduces the rates to 6%, Mr. X has effectively lost Rs. 6,000/- that year as interest income. This is called Re-investment Risk.
Laddering is a technique that can help us reduce this risk to a great extent. You can limit reinvestment risk by laddering, since you'll only have to reinvest part of your total fixed-income assets at any one time.
A FD ladder is made up by purchasing several FD's at one time with different maturity dates. One example of a FD ladder is to have maturity dates of one year, two years and three years. These three investments make up the three rungs of your FD ladder with one certificate maturing every year for the next Three years.
Mr. X had Rs. 3 lakhs to invest. He would buy 3 FD's for Rs. 1 lakh each with each one invested for one year more than the first. So he would have a 1 lakh FD maturing in one year, another in two years, and so on up to the last one which matures in Three years. Every year for the next three years one of his FD matures and earns you interest on his principal of 1 lakh.
When the deposit matures, he would roll it over into another FD. The best strategy is to purchase a new CD at the longest term, which in our example above would be three years. This strategy allows you to take advantage of the higher rates normally associated with longer-term FDs while maintaining more frequent access to part of your funds.
Let us say Mr. X needs Rs. 50,000/- at the end of the 6 months and he has no other cash sources apart from his FD’s. In the normal scenario, he would have had to pre-close his FD (which would attract a penalty & he would not get the normal Interest) and then re-invest the remaining money in a different FD which may or may not earn as much as the interest rates may have changed. But in our scenario, all Mr. X would need to do is, take Rs. 50,000/- from one of his FD’s and let the remaining 2 FD’s go on as planned thereby reducing the penalty and interest lost because of the unexpected emergency.
Another advantage to laddering your FD's is that over time it evens out the high and low interest rate cycles. Some years interest rates will be high, other years the rates will be lower. Currently banks are paying some of the highest FD rates we've seen in the last decade.
Before deciding on laddering your FD's, make sure you can afford to do without that money for a period of time. You'll pay a penalty for withdrawing your funds before your FD reaches maturity.
Also, don't get stuck on the idea that you have to invest in a 3-year ladder. You may be more comfortable with a five year ladder based on your financial needs. Or you may want to try a ladder with a 3 month, a 6 month, a 12 month, and a 24 month maturity. You can try a NSC ladder with 6 steps where you begin by buying NSC certificates every year for the next 6 years and then continue to Ladder it during subsequent years.
The benefits of laddering your FD investment is that you lower your risk of losing money when rates are low, increase your returns when rates are high, and still have access to a portion of your money, should you need it for an emergency.
Just like a normal ladder, our investment ladder also has a certain number of steps. This is determined by the initial number of investments that we would be ready to make. Let us take an example where a Bank FD ladder is formed by Mr. X.
Let us say Mr. X has idle cash of Rs. 3 lakhs and is willing to deposit it in a bank to ensure safety of the capital. Let us say the bank offers him an interest of 8% for one year and Mr. X invests it happily. At the end of the first year Mr. X would get Rs. 24,000/- as interest. Now if Mr. X wants to invest in the bank FD again, there is no guarantee that the bank would offer 8% or more. Based on the market interest rates, the bank may opt to reduce it. Let us say the bank reduces the rates to 6%, Mr. X has effectively lost Rs. 6,000/- that year as interest income. This is called Re-investment Risk.
Laddering is a technique that can help us reduce this risk to a great extent. You can limit reinvestment risk by laddering, since you'll only have to reinvest part of your total fixed-income assets at any one time.
A FD ladder is made up by purchasing several FD's at one time with different maturity dates. One example of a FD ladder is to have maturity dates of one year, two years and three years. These three investments make up the three rungs of your FD ladder with one certificate maturing every year for the next Three years.
Mr. X had Rs. 3 lakhs to invest. He would buy 3 FD's for Rs. 1 lakh each with each one invested for one year more than the first. So he would have a 1 lakh FD maturing in one year, another in two years, and so on up to the last one which matures in Three years. Every year for the next three years one of his FD matures and earns you interest on his principal of 1 lakh.
When the deposit matures, he would roll it over into another FD. The best strategy is to purchase a new CD at the longest term, which in our example above would be three years. This strategy allows you to take advantage of the higher rates normally associated with longer-term FDs while maintaining more frequent access to part of your funds.
Let us say Mr. X needs Rs. 50,000/- at the end of the 6 months and he has no other cash sources apart from his FD’s. In the normal scenario, he would have had to pre-close his FD (which would attract a penalty & he would not get the normal Interest) and then re-invest the remaining money in a different FD which may or may not earn as much as the interest rates may have changed. But in our scenario, all Mr. X would need to do is, take Rs. 50,000/- from one of his FD’s and let the remaining 2 FD’s go on as planned thereby reducing the penalty and interest lost because of the unexpected emergency.
Another advantage to laddering your FD's is that over time it evens out the high and low interest rate cycles. Some years interest rates will be high, other years the rates will be lower. Currently banks are paying some of the highest FD rates we've seen in the last decade.
Before deciding on laddering your FD's, make sure you can afford to do without that money for a period of time. You'll pay a penalty for withdrawing your funds before your FD reaches maturity.
Also, don't get stuck on the idea that you have to invest in a 3-year ladder. You may be more comfortable with a five year ladder based on your financial needs. Or you may want to try a ladder with a 3 month, a 6 month, a 12 month, and a 24 month maturity. You can try a NSC ladder with 6 steps where you begin by buying NSC certificates every year for the next 6 years and then continue to Ladder it during subsequent years.
The benefits of laddering your FD investment is that you lower your risk of losing money when rates are low, increase your returns when rates are high, and still have access to a portion of your money, should you need it for an emergency.
Common Investing Mistakes
Investment in the stock markets is something that many of us do very often and in many cases we end up suffering a loss. This is usually due to an error in judgement while choosing an investment instrument. This article is about the most common mistakes We as investors commonly make. Judging the market perfectly always is something nobody can do. Predicting market movement is a complex task and the chances of picking out a multibagger is the nearly the same as picking up a disaster of a stock. But, what we can do is, to be careful and take some precautions to ensure we dont lose our hard earned money.
The First Mistake: Going by word of mouth Tips
This is something we do all the time. A friend tells us a news about a stock that he heard from someone. The stock is expected to double or triple in a specific time and the friend went ahead and bought the stock. Most of us are tempted to go ahead and buy it ourselves. In all probabilities the stock could be a disaster and we can end up losing all our money. I did the same mistake when I started investing. A good friend of mine, who is a long term player suggested I buy stocks of a company that was expected to double up in the next 2 months. Believing my friend and his experience in the markets I went ahead and bought a decent number of shares of that company at Rs. 9.5/- each. The first week the stock reached a price of Rs. 10.5/- and I thought maybe my friend is right. But in the next few weeks the stock price started falling and currently the stock is trading at Rs. 0.75/- per share. I am glad that my exposure to this stock was less than 2% of my portfolio's worth and hence the profits I made out of the other stocks helped me recover the huge loss this stock brought to my portfolio.
The lesson is - Never rely on word of mouth tips. Do your own analysis. Find out more details about the company, its history, profit making capability etc before investing in it.
To learn some tips on how to pick a stock for your portfolio Click here
Mistake No 2: Not admitting making a mistake
People stubbornly hold on to stocks where they are making sizeable losses in the belief that they can exit when the price reaches their buying price. Most of the minds are not trained to acknowledge the fact that they have made a mistake and probably the best thing is to move on.
Mistake No 3: Buying on tips and emails from brokers and wanting to make a quick buck
Technology has made our lives much easier but at the same time has caused a lot of overload as well. We are subject to SMS's, emails and flyers with lucrative offers for “buy and sell tips” , commodities trading etc. that at the end of the day leave us confused. In this state only two things can happen, (a) One is that we procrastinate and not take any action with the fear of screwing it up or (b) Succumb to these offers for making us rich quickly.
Either ways the probability of facing a loss is pretty high. Never buy a stock until you have done your own analysis of the stock that you are going to buy.
Mistake No 4: Buying a disaster on its way down thinking you are averaging your costs
Mistake No 5: Ignoring Stock market Risks and looking only at the returns
Risk is an integral part of every equity investment and some equity investments are more risky than others. People however look at the returns without giving due importance to risk. Stock Futures can give you great returns but at the same time they can wipe out your capital as well. In the mutual fund context, people look at returns when investing in the fund, but do not consider the kind of risks the fund manager has taken whether it be concentration in stocks or sectors etc. At the same time betting heavily in Futures & Options, Commodities without understanding the nuances of the same is fraught with risk. Understand the risk i.e the downside inherent in every investment and volatility associated with it.
Mistake No 6: Buying penny stocks thinking they are cheaper and ignoring quality stocks, which are priced above a certain number like Rs. 1000/- or more thinking, they are expensive.
In most cases such blue chip stocks can give us better returns than a penny stock. For example the returns on one share of Reliance Industries stock bought at the beginning of the year 2009 when it was trading at around Rs. 1000/- on the current date could be more than the returns on 100 shares of stocks that are around the Rs. 10/- mark. The price of a stock must not determine our decision to buy it/
Mistake No 7: Exiting Winners early to make a small profit and sticking to Losers
Mistake No 8: Just thinking but not doing anything
This is probably the biggest mistake of all. Thinking about investing but doing nothing. Finally doing makes all the difference. There is no substitute for action. Just knowing that exercise is good will not keep you fit. In the same vein, just knowing this stock is good is of no use unless you buy it.
Some common statements from such people are:
“I knew this stock would do well, wish I had put in money here” or
“I missed a good time to enter this stock. It is too costly to invest now”
Whatever the reason be, in the end what matters is whether you did what you knew was right. A better option for people here is to put their investments on Autopilot - Choose quality mutual funds - investing fixed amounts every month in them.
To be a successful investor and create wealth through equities, you should shun & try to avoid the mistakes outlined above. And yes if you have made any one of the above mistakes, admit it and correct it. Mistakes are common. Even the best equity investor in the world would have made mistakes at some point of his time.
The First Mistake: Going by word of mouth Tips
This is something we do all the time. A friend tells us a news about a stock that he heard from someone. The stock is expected to double or triple in a specific time and the friend went ahead and bought the stock. Most of us are tempted to go ahead and buy it ourselves. In all probabilities the stock could be a disaster and we can end up losing all our money. I did the same mistake when I started investing. A good friend of mine, who is a long term player suggested I buy stocks of a company that was expected to double up in the next 2 months. Believing my friend and his experience in the markets I went ahead and bought a decent number of shares of that company at Rs. 9.5/- each. The first week the stock reached a price of Rs. 10.5/- and I thought maybe my friend is right. But in the next few weeks the stock price started falling and currently the stock is trading at Rs. 0.75/- per share. I am glad that my exposure to this stock was less than 2% of my portfolio's worth and hence the profits I made out of the other stocks helped me recover the huge loss this stock brought to my portfolio.
The lesson is - Never rely on word of mouth tips. Do your own analysis. Find out more details about the company, its history, profit making capability etc before investing in it.
To learn some tips on how to pick a stock for your portfolio Click here
Mistake No 2: Not admitting making a mistake
People stubbornly hold on to stocks where they are making sizeable losses in the belief that they can exit when the price reaches their buying price. Most of the minds are not trained to acknowledge the fact that they have made a mistake and probably the best thing is to move on.
Mistake No 3: Buying on tips and emails from brokers and wanting to make a quick buck
Technology has made our lives much easier but at the same time has caused a lot of overload as well. We are subject to SMS's, emails and flyers with lucrative offers for “buy and sell tips” , commodities trading etc. that at the end of the day leave us confused. In this state only two things can happen, (a) One is that we procrastinate and not take any action with the fear of screwing it up or (b) Succumb to these offers for making us rich quickly.
Either ways the probability of facing a loss is pretty high. Never buy a stock until you have done your own analysis of the stock that you are going to buy.
Mistake No 4: Buying a disaster on its way down thinking you are averaging your costs
Mistake No 5: Ignoring Stock market Risks and looking only at the returns
Risk is an integral part of every equity investment and some equity investments are more risky than others. People however look at the returns without giving due importance to risk. Stock Futures can give you great returns but at the same time they can wipe out your capital as well. In the mutual fund context, people look at returns when investing in the fund, but do not consider the kind of risks the fund manager has taken whether it be concentration in stocks or sectors etc. At the same time betting heavily in Futures & Options, Commodities without understanding the nuances of the same is fraught with risk. Understand the risk i.e the downside inherent in every investment and volatility associated with it.
Mistake No 6: Buying penny stocks thinking they are cheaper and ignoring quality stocks, which are priced above a certain number like Rs. 1000/- or more thinking, they are expensive.
In most cases such blue chip stocks can give us better returns than a penny stock. For example the returns on one share of Reliance Industries stock bought at the beginning of the year 2009 when it was trading at around Rs. 1000/- on the current date could be more than the returns on 100 shares of stocks that are around the Rs. 10/- mark. The price of a stock must not determine our decision to buy it/
Mistake No 7: Exiting Winners early to make a small profit and sticking to Losers
Mistake No 8: Just thinking but not doing anything
This is probably the biggest mistake of all. Thinking about investing but doing nothing. Finally doing makes all the difference. There is no substitute for action. Just knowing that exercise is good will not keep you fit. In the same vein, just knowing this stock is good is of no use unless you buy it.
Some common statements from such people are:
“I knew this stock would do well, wish I had put in money here” or
“I missed a good time to enter this stock. It is too costly to invest now”
Whatever the reason be, in the end what matters is whether you did what you knew was right. A better option for people here is to put their investments on Autopilot - Choose quality mutual funds - investing fixed amounts every month in them.
To be a successful investor and create wealth through equities, you should shun & try to avoid the mistakes outlined above. And yes if you have made any one of the above mistakes, admit it and correct it. Mistakes are common. Even the best equity investor in the world would have made mistakes at some point of his time.
Risks Involved in Investing in Bonds
Bonds are one of the most preferred investment instruments for the risk averse investor who wants a decent return on investment (ROI) and capital preservation at the same time. Bonds are debt obligations which pay out a fixed interest on the invested sum and pay back the whole invested principal at maturity. Unfortunately, Bonds are not so straight forward as they might sound. There are many risks involved in investing in Bonds. These risks can cause losses to the investors bond portfolio and defeat the whole purpose of capital preservation.
Some of the risks involved in investing in Bonds are:
1. Interest Rate Risk
2. Re-investment Risk
3. Call Risk
4. Default Risk &
5. Inflation Risk
Interest Rate Risk:
This is the most or well known risk in the bond market. This refers to the risk that bond prices will fall as the interest rates in the market rise. Bond prices are inversely proportional to the prevailing interest rates in the market. By buying a bond, the bondholder has committed to receiving a fixed rate of return for a fixed period. If the market interest rate rises from the date of the bond's purchase, the bond's price will fall accordingly. The bond will then be trading at a discount to reflect the lower return that an investor will make on the bond. The investor would end up suffering losses if he wishes to liquidate his holdings at that point of time.
Market interest rates are a function of several factors such as the demand for, and supply of, money in the economy, the inflation rate, the stage that the business cycle is in as well as the government's monetary and fiscal policies.
Reinvestment Risk
This refers to the risk that the proceeds from a bond will be reinvested at a lower rate than the bond originally provided. For example, imagine that an investor bought a $1,000 bond that had an annual coupon of 12%. Each year the investor receives $120 (12%*$1,000), which can be reinvested back into another bond. But imagine that over time the market rate falls to 1%. Suddenly, that $120 received from the bond can only be reinvested at 1%, instead of the 12% rate of the original bond. If the investor has chosen reinvestment as an option, he would end up hurting his investment.
Call Risk
This refers to the risk that a bond will be called by its issuer. Callable bonds have call provisions, which allow the bond issuer to purchase the bond back from the bondholders and retire the issue. This is usually done when interest rates have fallen substantially since the issue date. Call provisions allow the issuer to retire the old, high-rate bonds and sell low-rate bonds in a bid to lower debt costs. If an investor has exposure to such callable bonds, the bond issuer can retire the bond and reissue fresh ones, reducing his debt cost, thereby damaging the return prospects for the investor
Default Risk
The risk that the bond's issuer will be unable to pay the contractual interest or principal on the bond in a timely manner, or at all. This is one of the serious risk factors that need to be considered before investing in a bond. The main aim behind investing in bonds is capital preservation and if you invest in a company that is on the verge of going bankrupt, the investment is as good as flushing it down the drain. To help investors who do not have the time or the means to research into such instruments, Credit ratings services such as Moody's, Standard & Poor's and Fitch give credit ratings to bond issues, which helps to give investors an idea of how likely it is that a payment default will occur. For example, most federal governments have very high credit ratings (AAA); they can raise taxes or print money to pay debts, making default unlikely. However, small, emerging companies have some of the worst credit (BB and lower). They are much more likely to default on their bond payments, in which case bondholders will likely lose all or most of their investment. Investing in high rating instruments is a wise choice rather than choosing ones with lower ratings. But, there is a catch here, lower rating bonds usually offer higher ROI when compared to the higher rating ones. The Risk-Return trade off comes into picture here. To attract more investors, companies with a lower credit rating usually offer higher interest rates which might tempt the high risk investor to give it a try.
Inflation Risk
The risk that the rate of price increases in the economy deteriorates the returns associated with the bond. This has the greatest effect on fixed bonds, which have a set interest rate from inception. For example, if an investor purchases a 5% fixed bond and then inflation rises to 10% a year, the bondholder will lose money on the investment because the purchasing power of the proceeds has been greatly diminished. The interest rates of floating-rate bonds (floaters) are adjusted periodically to match inflation rates, limiting investors' exposure to inflation risk.
Some of the risks involved in investing in Bonds are:
1. Interest Rate Risk
2. Re-investment Risk
3. Call Risk
4. Default Risk &
5. Inflation Risk
Interest Rate Risk:
This is the most or well known risk in the bond market. This refers to the risk that bond prices will fall as the interest rates in the market rise. Bond prices are inversely proportional to the prevailing interest rates in the market. By buying a bond, the bondholder has committed to receiving a fixed rate of return for a fixed period. If the market interest rate rises from the date of the bond's purchase, the bond's price will fall accordingly. The bond will then be trading at a discount to reflect the lower return that an investor will make on the bond. The investor would end up suffering losses if he wishes to liquidate his holdings at that point of time.
Market interest rates are a function of several factors such as the demand for, and supply of, money in the economy, the inflation rate, the stage that the business cycle is in as well as the government's monetary and fiscal policies.
Reinvestment Risk
This refers to the risk that the proceeds from a bond will be reinvested at a lower rate than the bond originally provided. For example, imagine that an investor bought a $1,000 bond that had an annual coupon of 12%. Each year the investor receives $120 (12%*$1,000), which can be reinvested back into another bond. But imagine that over time the market rate falls to 1%. Suddenly, that $120 received from the bond can only be reinvested at 1%, instead of the 12% rate of the original bond. If the investor has chosen reinvestment as an option, he would end up hurting his investment.
Call Risk
This refers to the risk that a bond will be called by its issuer. Callable bonds have call provisions, which allow the bond issuer to purchase the bond back from the bondholders and retire the issue. This is usually done when interest rates have fallen substantially since the issue date. Call provisions allow the issuer to retire the old, high-rate bonds and sell low-rate bonds in a bid to lower debt costs. If an investor has exposure to such callable bonds, the bond issuer can retire the bond and reissue fresh ones, reducing his debt cost, thereby damaging the return prospects for the investor
Default Risk
The risk that the bond's issuer will be unable to pay the contractual interest or principal on the bond in a timely manner, or at all. This is one of the serious risk factors that need to be considered before investing in a bond. The main aim behind investing in bonds is capital preservation and if you invest in a company that is on the verge of going bankrupt, the investment is as good as flushing it down the drain. To help investors who do not have the time or the means to research into such instruments, Credit ratings services such as Moody's, Standard & Poor's and Fitch give credit ratings to bond issues, which helps to give investors an idea of how likely it is that a payment default will occur. For example, most federal governments have very high credit ratings (AAA); they can raise taxes or print money to pay debts, making default unlikely. However, small, emerging companies have some of the worst credit (BB and lower). They are much more likely to default on their bond payments, in which case bondholders will likely lose all or most of their investment. Investing in high rating instruments is a wise choice rather than choosing ones with lower ratings. But, there is a catch here, lower rating bonds usually offer higher ROI when compared to the higher rating ones. The Risk-Return trade off comes into picture here. To attract more investors, companies with a lower credit rating usually offer higher interest rates which might tempt the high risk investor to give it a try.
Inflation Risk
The risk that the rate of price increases in the economy deteriorates the returns associated with the bond. This has the greatest effect on fixed bonds, which have a set interest rate from inception. For example, if an investor purchases a 5% fixed bond and then inflation rises to 10% a year, the bondholder will lose money on the investment because the purchasing power of the proceeds has been greatly diminished. The interest rates of floating-rate bonds (floaters) are adjusted periodically to match inflation rates, limiting investors' exposure to inflation risk.
Subscribe to:
Posts (Atom)