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ACTSC 445 (24)

unit3 risk associated with investing in fixed income securiteis

3 Pages

Actuarial Science
Course Code
Jiahua Chen

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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. 1 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 inform
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