# Introduction to Financial Engineering Aashish Dhakal Week : Bond Risk.

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Introduction to Financial Engineering Aashish Dhakal Week : Bond Risk

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:

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)

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.

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.

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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