Bond Markets Analysis and Strategies 8th Edition by Frank J. Fabozzi Solution manual

 
Interest-Rate Risk
 
If an investor has to sell a bond prior to the maturity date, an increase in interest rates will mean the realization of a capital loss (i.e., selling the bond below the purchase price). This risk is referred to as interest-rate risk or market risk.
 
Reinvestment Income or Reinvestment Risk
 
Reinvestment risk is the risk that the interest rate at which interim cash flows can be reinvested will fall. Reinvestment risk is greater for longer holding periods, as well as for bonds with large, early, cash flows, such as high-coupon bonds. It should be noted that interest-rate risk and reinvestment risk have offsetting effects. That is, interest-rate risk is the risk that interest rates will rise, thereby reducing a bond’s price. In contrast, reinvestment risk is the risk that interest rates will fall.
 
Call Risk
 
Call risk is the risk investors have that a callable bond will be called when interest rates fall. Many bonds include a provision that allows the issuer to retire or “call” all or part of the issue before the maturity date. The issuer usually retains this right in order to have flexibility to refinance the bond in the future if the market interest rate drops below the coupon rate.
 
For investors, there are three disadvantages to call provisions. First, the cash flow pattern cannot be known with certainty. Second, the investor is exposed to reinvestment risk. Third, the capital appreciation potential of a bond will be reduced. Even though the investor is usually compensated for taking call risk by means of a lower price or a higher yield, it is not easy to determine if this compensation is sufficient.
 
Credit Risk
 
Credit risk is the risk that the issuer of a bond will fail to satisfy the terms of the obligation with respect to the timely payment of interest and repayment of the amount borrowed. This form of credit risk is called default risk. Market participants gauge the default risk of an issue by looking at the default rating or credit rating assigned to a bond issue by rating companies.
 
The yield on a bond issue is made up of two components: (1) the yield on a similar maturity Treasury issue and (2) a premium to compensate for the risks associated with the bond issue that do not exist in a Treasury issue—referred to as a spread. The part of the risk premium or spread attributable to default risk is called the credit spread. The risk that a bond price will decline due to an increase in the credit spread is called credit spread risk.
 
An unanticipated downgrading of an issue or issuer increases the credit spread sought by the market, resulting in a decline in the price of the issue or the issuer’s debt obligation. This risk is referred to as downgrade risk. Consequently, credit risk consists of three types of risk: default risk, credit spread risk, and downgrade risk.
 
Inflation Risk
 
Inflation risk or purchasing-power risk arises because of the variation in the value of cash flows from a security due to inflation, as measured in terms of purchasing power.
 
 
 
ANSWERS TO QUESTIONS FOR CHAPTER 1
 
(Questions are in bold print followed by answers.)
 
1. What is the cash flow of a 8-year bond that pays coupon interest semiannually, has a coupon rate of 6%, and has a par value of $100,000?
 
The principal or par value of a bond is the amount that the issuer agrees to repay the bondholder at the maturity date. The coupon rate multiplied by the principal of the bond provides the dollar amount of the coupon (or annual amount of the interest payment). An 8-year bond with a 6% annual coupon rate and a principal of $100,000 will pay semiannual interest of (0.06/2)($100,000) = $3,000 for 8(2) = 16 periods. Thus, the cash flow is $3,000. In addition to this periodic cash, the issuer of the bond is obligated to pay back the principal of $100,000 at the time the last $3,000 is paid.
 
2. What is the cash flow of a 4-year bond that pays no coupon interest and has a par value of $1,000?
 
There is no periodic cash flow as found in the previous problem. Thus, the only cash flow will be the principal payment of $1,000 received at the end of six years. This type of cash flow resembles a zero-coupon bond. The holder of such a bond realizes interest by buying the bond substantially below its principal value. Interest is then paid at the maturity date, with the exact amount being the difference between the principal value and the price paid for the bond.
 
3. Give three reasons why the maturity of a bond is important.
 
There are three reasons why the maturity of a bond is important. First, the maturity gives the time period over which the holder of the bond can expect to receive the coupon payments and the number of years before the principal will be paid in full. Second, the maturity is important because the yield on a bond depends on it. The shape of the yield curve determines how the maturity affects the yield. Third, the price of a bond will fluctuate over its life as yields in the market change. The volatility of a bond’s price is dependent on its maturity. More specifically, with all other factors constant, the longer the maturity of a bond, the greater the price volatility resulting from a change in market yields.