Page 63 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes 2. Interest Rate Risk: The variability in a security's return resulting from changes in the
level of interest rates is referred to as interest rate risk. Such changes generally affect
securities inversely; that is, other things being equal, security prices move inversely to
interest rates. The reason for this movement is tied up with the valuation of securities.
Interest rate risk affects bonds more directly than common stocks and is a major risk that
all bondholders face. As interest rates change, bond prices change in the opposite direction.

3. Purchasing Power Risk: A factor affecting all securities is purchasing power risk, also
known as inflation risk. This is the possibility that the purchasing power of invested
dollars will decline. With uncertain inflation, the real (inflation-adjusted) return involves
risk even if the nominal return is safe (e.g., a Treasury bond). This risk is related to interest
rate risk, since interest rates generally rise as inflation increases, because lenders demand
additional inflation premiums to compensate for the loss of purchasing power.
4. Regulation Risk: Some investments can be relatively attractive to other investments
because of certain regulations or tax laws that give them an advantage of some kind.
Municipal bonds, for example, pay interest that is exempt from local, state and federal
taxation. As a result of that special tax exemption, municipals can price bonds to yield a
lower interest rate since the net after-tax yield may still make them attractive to investors.
The risk of a regulatory change that could adversely affect the stature of an investment is
a real danger. In 1987, tax law changes dramatically lessened the attractiveness of many
existing limited partnerships that relied upon special tax considerations as part of their
total return. Prices for many limited partnerships tumbled when investors were left with
different securities, in effect, than what they originally bargained for. To make matters
worse, there was no extensive secondary market for these illiquid securities and many
investors found themselves unable to sell those securities at anything but 'fire sale' prices
if at all.
5. Business Risk: The risk of doing business in a particular industry or environment is called
business risk. For example, as one of the largest steel producers, U.S. Steel faces unique
problems. Similarly, General Motors faces unique problems as a result of such
developments as the global oil situation and Japanese imports.
6. Reinvestment Risk: The YTM calculation assumes that the investor reinvests all coupons
received from a bond at a rate equal to the computed YTM on that bond, thereby earning
interest on interest over the life of the bond at the computed YTM rate. In effect, this
calculation assumes that the reinvestment rate is the yield to maturity.
If the investor spends the coupons, or reinvests them at a rate different from the assumed
reinvestment rate of 10%, the realized yield that will actually be earned at the termination
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 realised 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

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