Risk faced-1 - Financial Economics by ClassOf1

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Explain the two main risks bondholders face : After doing some research on the Internet, Mark is considering investing his life savings in corporate bonds. He’s not really sure what they are, however, and wants you to explain them to him.

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									              Sub: Economics                                                             Topic: Financial Economics



              Question:

               Explain the two main risks bondholders face?

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              After doing some research on the Internet, Mark is considering investing his life savings in
              corporate bonds. He's not really sure what they are, however, and wants you to explain them
              to him
              Explain the two main risks bondholders face?


              Solution:
              Reinvestment risk: When interest rates are declining, investors have to reinvest their interest
              income and any return of principal, whether scheduled or unscheduled, at lower prevailing
              rates.
              Inflation risk: Inflation causes tomorrow’s dollar to be worth less than today’s; in other words,
              it reduces the purchasing power of a bond investor’s future interest payments and principal,
              collectively known as “cash flows.” Inflation also leads to higher interest rates, which in turn
              leads to lower bond prices. Inflation-indexed securities such as Treasury Inflation Protection
              Securities (TIPS) are structured to remove inflation risk.

                                                          ** End of the Solution **


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