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Introduction to Financial Engineering Aashish Dhakal Week : Bond Risk

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Risk With Bond: Even we say bond are risk free investment, we have various associated risk with the bond 1.Inflation Risk: 2.Interest Rate Risk: 3.Default Risk: 4.Liquidity Risk: 5.Reinvestment Risk:

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Risk With Bond: 1.Inflation Risk: Inflation refers to rise in the price of a products & consequent fall in the value of money. Suppose we have a product today at Rs 100 and the same product after one year price Rs 108. Here we can say the price of product has increased by 8%. Every Product in the basket of product holds inflation risk. Every investment must cover inflation risk. Suppose, we have deposited a money into Fixed Deposit @ 8% and the inflation economy is 3% our real rate of return is 5% (i.e. 8-3)

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Risk With Bond: 2. Interest Rate Risk: Interest Rate doesn’t remain static. They move up and down unannounced. Interest Rate Risk demotes to the IMPACT that rising interest rate will have on bond value. If market Interest Rate Increases, the value of bond comes down. If market interest Rate Falls, value of bond goes up.

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Risk With Bond: 3. Default Risk: This refer to t he possibility that not only the Promised Rate of Return is Not Paid BUT that the principal amount of Investment too could be lost. Default Risk is higher in case of investment in companies which have speculative grading, companies being run by first generation entrepreneurs. This risk is also called market risk 4. Liquidity Risk: Risk that it may take long time to be converted into cash without loss of value. Even Bonds are liquid asset, however it holds some quantum of Liquidity Risk.

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Risk With Bond: 5. Reinvestment Risk: Any Investment gives Return in the course of its life. EG: Fixed Deposit Pay INTEREST Stock Pays Dividends In arriving at the rate of return from these investment, we assume that interveining cash flow are re-invested at same rate. However, if they cannot be re-invested at the same rate but have to be invested at lower rate that the investment is said to have re-investment risk.

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