ACTSC445 Lecture Notes - Reinvestment Risk, Prepayment Of Loan, United States Treasury Security

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ACTSC 445: Asset-Liability Management
Department of Statistics and Actuarial Science, University of Waterloo
Unit 3 – Risks associated with investing in fixed income securities
References (recommended readings): Chap. 2 of Fabozzi et al.
When investing in a FIS, the return on the investment depends on different factors, and comes from
two different parts:
1. The market value of the security when it is sold (if sold before maturity).
2. The cash flows received from the security over the time period that it is held , plus any additional
income from reinvestment of the cash flow.
These two potential sources of return are exposed to several risks, which we now discuss.
Market, or interest-rate risk
Typically, the value of a FIS decreases as interest rates increase. Thus, for the owner of a FIS who
needs to sell when interest rates on the market are rising, a loss occurs. This risk is the market risk,
and is the most important one for investors in the FIS market.
The benchmark used to monitor changes in interest rates is usually the yield level on Treasury securities.
The interest-rate risk is typically quantified by using a measure called duration, which we will discuss
later on. Roughly, the duration gives us a way to approximate by how much the price of a security will
change if the interest rates change.
Reinvestment risk
The return obtained when reinvesting the cash flows produced by a FIS depends on the interest rates
prevailing when these cash flows are reinvested. The risk is that the interest rates will be low when the
cash flows become available for reinvestment.
Timing, or call, risk
When a bond is callable, this can potentially be harmful to the investor in different ways. First, the
cash flows become uncertain; second, the issuer will typically call the bond when interest rates drop,
which will expose the investor to reinvestment risk. Another version of this risk is for the investor of a
MBS, in which the cash flows depend on the prepayments made by the homeowners. The timing risk
in this case is called prepayment risk.
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