Page 67 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes of the investment in the bond will differ from the promised YTM. And, in fact, coupons
almost always will be reinvested at rates higher or lower than the computed YTM, resulting
in a realized yield that differs from the promised yield. This gives rise to reinvestment
rate risk. This interest-on-interest concept significantly affects the potential total dollar
return. Its exact impact is a function of coupon and time to maturity, with reinvestment
becoming more important as either coupon or time to maturity, or both, rise. Specifically:
(a) Holding everything else constant, the longer the maturity of a bond, the greater the
reinvestment risks.
(b) Holding everything else constant, the higher the coupon rate, the greater the
dependence of the total dollar returns from the bond on the reinvestment of the
coupon payments.
Let's look at realized yields under different assumed reinvestment rates for a 10% non-
callable 20-year bond purchased at face value. If the reinvestment rate exactly equals the
YTM of 10%, the investor would realize a 10% compound return when the bond is held to
maturity, with $4,040 of the total dollar return from the bond attributable to interest on
interest. At a 12% reinvestment rate, the investor would realize an 11.14% compound
return, with almost 75% of the total return coming from interest-on-interest ($5,738/
$7,738). With no reinvestment of coupons (spending them as received), the investor would
achieve only a 5.57% return. In all cases, the bond is held to maturity.

Clearly, the reinvestment portion of the YTM concept is critical. In fact, for long-term
bonds the interest-on-interest component of the total realized yield may account for more
than three-fourths of the bond's total dollar return.
7. Bull-Bear Market Risk: This risk arises from the variability in the market returns resulting
from alternating bull and bear market forces. When security index rises fairly consistently
from a low point, called a trough, over a period of time, this upward trend is called a bull
market. The bull market ends when the market index reaches a peak and starts a downward
trend. The period during which the market declines to the next trough is called a bear
market.

8. Management Risk: Management, all said and done, is made up of people who are mortal,
fallible and capable of making a mistake or a poor decision. Errors made by the management
can harm those who invested in their firms. Forecasting errors is difficult work and may
not be worth the effort and, as a result, imparts a needlessly sceptical outlook.
An agent-principal relationship exists when the shareholder owners delegate the day-to-
day decision-making authority to managers who are hired employees rather than
substantial owners. This theory suggests that owners will work harder to maximize the
value of the company than employees will. Various researches in the field indicate that
investors can reduce their losses to difficult-to-analyse management errors by buying
shares in those corporations in which the executives have significant equity investments.
9. Default Risk: It is that portion of an investment's total risk that results from changes in the
financial integrity of the investment. For example, when a company that issues securities
moves either further away from bankruptcy or closer to it, these changes in the firm's
financial integrity will be reflected in the market price of its securities. The variability of
return that investors experience, as a result of changes in the credit worthiness of a firm in
which they invested, is their default risk.
Almost all the losses suffered by investors as a result of default risk are not the result of
actual defaults and/or bankruptcies. Investor losses from default risk usually result from
security prices falling as the financial integrity of a corporation's weakness - market prices
of the troubled firm's securities will already have declined to near zero. However, this is

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