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

 
15. How do market participants gauge the default risk of a bond issue?
 
It is common to define credit risk as 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 one of the three rating companies—Standard & Poor’s, Moody’s, and Fitch.
 
16. Comment on the following statement: Credit risk is more than the risk that an issuer will default.
 
There are risks other than default that are associated with investment bonds that are also components of credit risk. Even in the absence of default, an investor is concerned that the market value of a bond issue will decline in value and/or the relative price performance of a bond issue will be worse than that of other bond issues.
 
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 price performance of a non-Treasury debt obligation and its return over some investment horizon will depend on how the credit spread of a bond issue changes. If the credit spread increases—investors say that the spread has “widened”—the market price of the bond issue will decline. The risk that a bond issue will decline due to an increase in the credit spread is called credit spread risk. This risk exists for an individual bond issue, bond issues in a particular industry or economic sector, and for all bond issues in the economy not issued by the U.S. Treasury.
 
17. Explain whether you agree or disagree with the following statement: “Because my bond is guaranteed by an insurance company, I have eliminated credit risk.”
 
Credit risk consists of three types of risk: default risk, credit spread risk, and downgrade risk. These risks are not necessarily eliminated if there is a financial guaranty by a nongovernment third-party entity such as a private insurance company. This is because insurance companies themselves can face financial difficulties. This fact was brought home to market participants at the end of 2007 when specialized insurance companies that provide financial guarantees faced financial difficulties and the downgrading of their own credit rating. Thus, one would disagree with the statement because one’s bond guarantee is only as good as the insurance company guaranteeing it.
 
18. Answer the below questions.
 
(a) What is counterparty risk?
 
Counterparty risk is a form of credit risk that involves transactions between two parties in a trade. The risk to each party of a contract is that the counterparty (or other party) will not be able to live up to its contractual obligations. In financial contracts, counterparty risk is known as “default risk.”
 
(b) Give two examples of transactions where one faces counterparty risk.
 
For a first example of counterparty risk, consider the strategy of a borrower using the borrowed funds from a lender to purchase another asset such as a bond. In this transaction, the lender is exposed to counterparty risk. Counterparty risk is the risk that the borrower will fail to repay the loan if his bond purchase defaults. A second example of counterparty risk involves a trade in a derivative (which is an investment that derives its value from the value of an underlying asset). A derivative, such as an option or a futures contract, is traded on an exchange that becomes the ultimate counterparty to the trade as it guarantees payments on money owed to the purchaser of the derivative instrument. For derivative instruments that are over-the-counter instruments, the counterparty is an entity other than an exchange. In such trades, there is considerable concern with counterparty risk.
 
 
19. Does an investor who purchases a zero-coupon bond face reinvestment risk?
 
The calculation of the yield of a coupon paying bond assumes that the cash flows received are reinvested at the prevailing rate when the coupon payment is received. Because this rate is not known in advance it creates uncertainty and so it is called by the name of reinvestment risk to indicate there is risk or uncertainty in the reinvesting of coupon payments.
 
For zero-coupon bonds, unlike bonds that pay a stream of coupon payments over time, the payment is reinvested at the same rate as the coupon rate. This eliminates any risk associated with the possibility that coupon payments will be reinvested at a lower rate. However, if rates go up, then the zero coupon bond will fall in value because its “locked-in” rate is below the higher market rate.