Interest-rate risk on bonds
The price of a typical bond will change in the opposite direction from a change in interest rates. As interest rates rise, the price of a bond will fall; as interest rates fall, the price of a bond will rise. The actual degree of sensitivity of a bond’s price to changes in market interest rates depends on various characteristics of the issue maturity, coupon and special provisions.
Similar financial termsReinvestment risk on bonds
Usually, when the yield of a bond is calculated, you assume that the coupons received before maturity are reinvested. The additional income from such reinvestment is sometimes referred to as interest-on-interest which depends on the prevailing interest-rate levels at the time of reinvestment. Volatility in the reinvestment rate of a given strategy because of changes in market interest rates is called reinvestment risk. This risk is that the interest rate at which interim cash flows can be reinve ...
Call risk on bonds
Many bonds include a call feature that allows the issuer to redeem or “call” all or part of the issue before the maturity date. The issuer usually retains this right in order to have flexibility to refinance the bond in the future if the market interest rate drops below the coupon rate. This implies three risks from the investor: (a) The cash flow pattern becomes uncertain, (b) The investor becomes exposed to reinvestment risk because the issuer will call the bond when interest rates drop, and ( ...
Default risk on bonds
Issuers that potentially run into cash flow problems, simultaneously attaches default risk to their bonds if there is uncertainty whether they can afford to pay coupons and principals. Bonds with default risk trade in the market at a price that is lower than comparable U.S. Treasury securities, which are considered free of default risk. Default risk is gauged by quality ratings assigned by recognised rating companies such as Moody’s Investor Service, Standard & Poor’s Corporation, Morningstar an ...
Inflation risk on bonds
If investors purchase a bond on which they can realize a coupon rate of 5% but the rate of inflation is 6%, the purchasing power of the cash flow actually has declined. Inflation risk arises because of the variation in the value of cash flows from a security due to inflation, as measured in terms of purchasing power.
Exchange-rate risk on bonds
A non-domestic-currency nominated bond has unknown domestic currency cash flows. The domestic currency cash flows are dependent on the exchange rate at the time the payments are received. For example, suppose that a German investor purchases a bond whose payments are in British pounds (GBP). If pounds depreciate relative to euros (EUR), fewer euros will be received and vice versa. This risk is also referred to currency risk.
Liquidity risk on bonds
The primary measure of liquidity is the size of the bid-ask spread. Liquidity risk depends on the ease with which an issue can be sold at or near its value. It follows that the wider the dealer spread, the more liquidity risk.
The practice of buying the stock of takeover targets after a merger is publicly announced and hold the stock until the deal is officially accomplished.
The systematic risk of an asset or portfolio is the risk that cannot be diversified away.
The risk in the value of options portfolios due to the unpredictable changes in the volatility of the underlying asset.
A value-at-risk (VAR) model is a procedure for estimating the probability of portfolio losses exceeding some specified proportion based on a statistical analysis of historical market price trends, correlations, and volatilities.
Also called the diversifiable risk or residual risk. The risk that is unique to a company such as a strike, the outcome of unfavorable litigation, or a natural catastrophe that can be eliminated through diversification.
Also called unsystematic risk or idiosyncratic risk. Specific company risk that can be eliminated through diversification.
Systematic risk principle
Only the systematic portion of risk matters in large, well-diversified portfolios. The expected returns must be related only to systematic risks.
The risk that a central bank will impose foreign exchange regulations that will reduce or negate the value of FX contracts. Also refers to the risk of government default on a loan made to it or guaranteed by it.
The risk of falling short of any investment target.
The rate earned on a riskless asset.
An asset whose future return is known today with certainty.
Return earned on an asset normalized for the amount of risk associated with that asset.
An asset whose future return is uncertain.
The simultaneous purchase and sale of the same asset to yield a profit.
Riskless rate of return
The rate earned on a riskless asset.
Risk premium approach
The most common approach for tactical asset allocation to determine the relative valuation of asset classes based on expected returns.
The reward for holding the risky market portfolio rather than the risk-free asset. The spread between Treasury and non-Treasury bonds of comparable maturity.
Willing to pay money to transfer risk from others.
Insensitive to risk.
The process of identifying and evaluating risks and selecting and managing techniques to adapt to risk exposures.
A person willing to accept lower expected returns on prospects with higher amounts of risk.
Categories of risk used to calculate fundamental beta, including (a) market variability, (b) earnings variability, (c) low valuation, (d) immaturity and smallness, (e) growth orientation, and (f) financial risk.
Risk controlled arbitrage
A self-funding, self-hedged series of transactions that generally utilize mortgage securities as the primary assets.
Groups of projects that have approximately the same amount of risk.
A risk-averse investor is one who, when faced with two investments with the same expected return but two different risks, prefers the one with the lower risk.
A probability used to determine a "sure" expected value (sometimes called a certainty equivalent) that would be equivalent to the actual risky expected value.
Typically defined as the standard deviation of the return on total investment. Degree of uncertainty of return on an asset.
Reverse price risk
A type of mortgage-pipeline risk that occurs when a lender commits to sell loans to an investor at rates prevailing at application but sets the note rates when the borrowers close. The lender is thus exposed to the risk of falling rates.
The risk that proceeds received in the future will have to be reinvested at a lower potential interest rate.
Regulatory pricing risk
Risk that arises when regulators restrict the premium rates that insurance companies can charge.
In banking, the risk that profits may decline or losses occur because a rise in interest rates forces up the cost of funding fixed-rate loans or other fixed-rate assets.
A type of mortgage-pipeline risk that occurs when a lender has an unusual loan in production or inventory but does not have a sale commitment at a prearranged price.
The risk that the value of a security (or a portfolio) will decline in the future. Or, a type of mortgage-pipeline risk created in the production segment when loan terms are set for the borrower in advance of terms being set for secondary market sale. If the general level of rates rises during the production cycle, the lender may have to sell his originated loans at a discount.
Possibility of the expropriation of assets, changes in tax policy, restrictions on the exchange of foreign currency, or other changes in the business climate of a country.
Overnight delivery risk
A risk brought about because differences in time zones between settlement centers require that payment or delivery on one side of a transaction be made without knowing until the next day whether the funds have been received in an account on the other side. Particularly apparent where delivery takes place in Europe for payment in dollars in New York.
The inherent or fundamental risk of a firm, without regard to financial risk. The risk that is created by operating leverage. Also called business risk.
Nonmarket or firm-specific risk factors that can be eliminated by diversification. Also called unique risk or diversifiable risk. Systematic risk refers to risk factors common to the entire economy.
Risk that cannot be eliminated by diversification.
The risk associated with taking applications from prospective mortgage borrowers who may opt to decline to accept a quoted mortgage rate within a certain grace period.
Risk that cannot be diversified away.
Market price of risk
A measure of the extra return, or risk premium, that investors demand to bear risk. The reward-to-risk ratio of the market portfolio.
The risk that arises from the difficulty of selling an asset. It can be thought of as the difference between the "true value" of the asset and the likely price, less commissions.
The risk that a firm will be unable to meet its debt obligations. Also referred to as default or insolvency risk.
The uncertainty about the basis at the time a hedge may be lifted. Hedging substitutes basis risk for price risk.
The risk that the cash flow of an issuer will be impaired because of adverse economic conditions, making it difficult for the issuer to meet its operating expenses.
The combination of cash flow uncertainty and reinvestment risk introduced by a call provision.
The risk that a foreign debtor will be unable to pay its debts because of business events, such as bankruptcy.
The risk that a project will not be brought into operation successfully.
The risk that the other party to an agreement will default. In an options contract, the risk to the option buyer that the option writer will not buy or sell the underlying as agreed.
Country economic risk
Developments in a national economy that can affect the outcome of an international financial transaction.
Country financial risk
The ability of the national economy to generate enough foreign exchange to meet payments of interest and principal on its foreign debt.
General level of political and economic uncertainty in a country affecting the value of loans or investments in that country.
The risk that an issuer of debt securities or a borrower may default on his obligations, or that the payment may not be made on a negotiable instrument.
Refers to the volatility of returns on international investments caused by events associated with a particular country as opposed to events associated solely with a particular economic or financial agent.
Currency risk sharing
An agreement by the parties to a transaction to share the currency risk associated with the transaction. The arrangement involves a customized hedge contract embedded in the underlying transaction.
Risk-adjusted return on capital (RAROC)
Measures performance on a risk-adjusted basis. Calculated as the economic return divided by economic capital. RAROC helps determine if a company has the right balance between capital, returns and risk. The central concept in RAROC is economic capital: the amount of capital a company should put aside needed based on the risk it runs.
Equilibrium market price of risk
The slope of the capital market line (CML). Since the CML represents the expected return offered to compensate for a perceived level of risk, each point on the line is a balanced market condition, or equilibrium. The slope of the line determines the additional expected return needed to compensate for a unit change in risk. The equation of the CML is defined by the Capital Asset Pricing Model (CAPM).
The uncertainty that an option position may be exercised into the underlying instrument. It is risky because it often refers to markets flirting with the prevailing at-the-money level. At such times, the gamma on a position is very erratic and difficult to hedge. Also, there are doubts about the exercise or assignment process. A trader can experience significant changes in net positions due to option exercises.
Money put up by ordinary shareholders, an individual entrepreneur or venture capitalist that will be lost if the enterprise fails.
Bonds with a maturity of between one and five years.
Medium-term or intermediate-term bonds
Bonds with a maturity of between five and twelve years.
Bonds with a maturity of more than 12 years.
The holder of a zero-coupon bond realizes interest by buying the bond at a discount to its principal value. These bonds made their debut in the U.S. bond market in the early 1980s.
Bonds that let the issuer avoid using cash to make interest payments for a specified number of years. There are three types of deferred-coupon structures: (a) deferred-interest bonds, (b) step-up bonds and (c) payment-in-kind bonds.
Call feature on bonds
A call feature grants the issue the right to retire the debt, fully or partially, before the scheduled maturity date. Inclusion of a call feature benefits bond issuers by allowing them to replace an old bond issue with a lower-interest cost issue if interest rates in the market fall.
Put provision on bonds
A put provision grants the bondholder the right to sell the issue back to the issuer at par value on designated dates. Here the advantage to the investor is that if interest rates rise after the issue date, thereby reducing a bond’s price, the investor can force the issuer to redeem the bond at par value.
Bonds that trade below investment grade set by recognised rating companies such as Moody’s Investor Service (Baa3), Standard & Poor’s Corporation (BBB), Morningstar and Fitch IBCA.
Brady bonds are issued by emerging countries under a debt-reduction plan named after former U.S. Secretary of the Treasury Nicholas Brady. Brady bonds were set up in association with the IMF and World Bank to sponsor the restructuring of outstanding sovereign loans and interest arrears into liquid debt instruments.
The conventional bonds form the largest part of the UK gilt market. 73% of bonds oustanding are in this form. COnventional bonds have a fixed coupon and a bullet (i.e. a fixed) maturity. Current coupons range from 2% to 13.5%. At the moment (2004), the longest outstanding maturity is 2036.
Bonds with a fixed maturity but not subject to prior redemption; bonds that cannot be called for redemption by the issuer (payer or obligor) before maturity. They should not be confused with perpetual bonds or intermediate bonds. UK Irredeemable (undated) bonds have no final maturity date. They are callable by the government at any time within 3 months. As their coupons range between 2.5% and 4% they are unlikely to be called. War loan, issued by the UK government during the First World War ...
Yankee bonds are issued by foreign governments and corporations, are generally dollar denominated, trade in the U.S., and must register with the Security and Exchange Commission. Issuers in the Yankee bond market are predominately highly-rated sovereign, or sovereign guaranteed issuers, although foreign corporations and financial institutions have increased issuance of Yankee bonds over the last decade.
Issuance in the Yankee bond market is dependent on U.S. interest rates, and the valu ...
Foreign bonds issued in Spain.
Foreign bonds issued in Netherlands.
Foreign bonds issued in Japan.
Foreign bonds issued in the United Kingdom.
Shogun bonds consist of foreign-currency bonds issued in Tokyo in currencies other that Japanese yen (JPY).
Yankee ECU bonds
Yankee ECU bonds refers to foreign-currency bonds issued in New York or Chicago in currencies other that US dollar.
Often referred to as bullet-maturity bonds or simply bullet bonds, bonds whose principal is payable at maturity.
Bonds with short current maturities.
Corporate bonds arranged so that specified principal amounts become due on specified dates.
Bonds with a long current maturity. The "long bond" is the 30-year U.S. government bond.
Collateral trust bonds
A bond in which the issuer (often a holding company) grants investors a lien on stocks, notes, bonds, or other financial asset as security.
Bonds that can be converted into common stock at the option of the holder.
Debt obligations issued by corporations.
High-coupon bonds that sell at only at a moderate premium because they are callable at a price below that at which a comparable non-callable bond would sell. Cushion bonds offer considerable downside protection in a falling market.
General Obligation Bonds
Securities issued by municipalities. The source of revenue to pay the interest and principal is taxes. These securities are also known as full faith and credit issues because they depend on the municipality's capacity to tax. These issues are often considered to be more stable than Revenue Bonds.
The capital portion of a bond from which the coupons have been stripped. The holder of the strip bond is entitled to its par value at maturity, but not the annual interest payments.