Reading 61: Risks Associated with Investing in Bonds LOSa习 2010, investing, interest, border

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LOS a: Explain the risks associated with investing in bonds.

Interest rate risk for a bond refers to the fact that when interest rates:

A) decrease, the realized yield on the bond will be less than the yield to maturity.

B) increase, prepayments of principal will decrease.

C) increase, the bond’s value decreases.

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Interest rate risk is the risk that the bond’s value will decrease because interest rates increase. Reinvestment risk is the risk that a bond’s cash flows will be reinvested at lower-than-expected rates. Prepayment risk refers to the fact that prepayments of a mortgage-backed security’s principal may differ from the expected rate.

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The interest rate risk of a bond is the:

A) risk related to the possibility of bankruptcy of the bond's issuer.

B) risks related to the possibility of bankruptcy of the bond's issuer and that arises from the uncertainty of the bond's return caused by the change in interest rates.

C) risk that arises from the uncertainty about the bond's return caused by changes in interest rates over time.

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Interest rate risk is the probability of an increase in interest rates causing a bond's price to decrease.

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Which of the following situations lead to short-term profit opportunities in the bond market?

A) Inflation is expected to rise.

B) Yields of all maturities start to rise.

C) Interest rates become more volatile.

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As interest rates become more volatile, accurate pricing of bonds becomes more difficult, and thus some bonds are likely to be priced incorrectly. This pricing discrepancy will allow for short-term profit opportunities by buying a bond that is priced too low and selling it at the market rate. Increases in inflation expectations or yield to maturities indicate increasing market required rates of returns for bonds. Bond prices typically have an inverse relationship to interest rates.

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Biggs, Inc., holds a bond portfolio that is, on average, trading below par value. They have faced some cash flow problems of late and have used the bond interest payments for operating expenses. The bonds are callable. Given the current situation, Biggs faces which types of risk?

A) Interest rate risk.

B) Interest rate risk and call risk.

C) Call risk.

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The bonds are trading below par, so rates have increased and, at this point, call risk is not significant. The firm faces interest rate risk because their bond portfolio has decreased in value due to increasing market interest rates.