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Lecture

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


Department
Actuarial Science
Course Code
ACTSC445
Professor
Jiahua Chen

Page:
of 3
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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Credit Risk
This includes two potential risks: (1) the issuer may default on its obligation (default risk); (2) the
value of the bond might decrease due to a decline in the credit rating of the issuer.
Yield-curve, or maturity risk
The yield curve refers to the information that gives the yield to maturity for bonds with different
maturities (will be discussed in details in Unit 4). This information can be used to infer about the
future behavior of interest rates. If an investor makes decisions based on inferences extracted from the
yield curve (for example, within a hedging strategy), then the return obtained might be affected by
deviations between the actual interest rates that will prevail and those inferred from the yield curve.
Inflation, or purchasing power, risk
Inflation affects the value of future cash flows, when we measure this value in terms of purchasing
power. Unless the bond contains an inflation-adjustment clause, the investor is exposed to this risk.
Liquidity, or marketability, risk
If an investor has to sell when there is a large bid-ask spread (which is an indication of a decreased
liquidity for that security), then the amount of money received is in some sense lower than the true
value of the security.
Exchange-rate, or currency, risk
A bond in currency X has unknown cash flows in currency Y. Their value depends on what the exchange
rate between X and Y (i.e., how many Y’s do you get for one unit of X) is at the time where it is
received. If the exchange rate decreases, then the value of the cash flows will decrease as well. Holding
bonds from another country also exposes the investor to the interest-rate risk from that other country.
Volatility Risk
Volatility in interest rates affect the value of options embedded in bonds (or in MBS). More precisely, the
value of these options typically increases with the volatility. If these options are granting privileges to
the issuer, it means that the price of the corresponding security will decrease when volatility increases,
thereby exposing the investor to a volatility risk.
Political or legal risk
Certain policies and regulations might affect the value of a FIS (for instance, a change in taxation
rules).
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Event risk
The ability of an issuer to meet its obligations might be affected by a serious and unexpected change
due to a sudden event:
a natural or industrial accident
a takeover or corporate restructuring
Sector risk
This risk is due to the possibility of adverse differential movements of specific sectors of the market.
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