EECS 1541 Lecture Notes - Lecture 36: Interest Rate Risk, Liquidity Risk, Credit Risk
24 Jun 2018
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EECS 1541 Lecture 36 Notes
Introduction
Liquidity Risk
Because international bonds are commonly sold in secondary markets, investors must
worry about any type of risk that could cause the price of the bonds to decline by the
time they wish to sell the bonds.
From the perspective of investors, international bonds are subject to four forms of risk:
interest rate risk, exchange rate risk, liquidity risk, and credit (default) risk.
Interest Rate Risk
The interest rate risk of international bonds is the potential for their value to decline in
response to rising long-term interest rates.
When long-term interest rates rise, the required rate of return by investors rises.
In that case, the discount rate used by investors to measure the present value of future
expected cash flows of bonds also rises.
Therefore, the valuations of bonds decline.
Even bonds with no exposure to credit risk tend to experience a decline in value when
interest rates rise.
Interest rate risk is more pronounced for fixed rate than for floating rate bonds because
the coupon rate remains fixed on fixed-rate bonds even when interest rates rise.
Hence the market price of these bonds must be reduced to compensate investors for
accepting a coupon rate that is below the return required by investors.
Exchange Rate
Risk Exchange rate risk is the potential for a bond’s value to decline (from the investor’s
perspective) because the currency denominating the bond depreciates against the
investor’s home currency.
Document Summary
Because international bonds are commonly sold in secondary markets, investors must worry about any type of risk that could cause the price of the bonds to decline by the time they wish to sell the bonds. The interest rate risk of international bonds is the potential for their value to decline in response to rising long-term interest rates. Hence the market price of these bonds must be reduced to compensate investors for accepting a coupon rate that is below the return required by investors. Risk exchange rate risk is the potential for a bond"s value to decline (from the investor"s perspective) because the currency denominating the bond depreciates against the investor"s home currency. As a result, the future expected coupon or principal payments to be received from the bond may convert to a smaller amount of the investor"s home currency. International bonds are commonly sold in secondary markets.
