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Business & Finance
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Assume that someone asks you for some advice on investing in bonds. You are fully aware of the five risk categories explained in Chapter 10. Assume that the person asking for advice would like to know your opinion on which risk is the one in which to be most cautious. Which risk is it and why? Furthermore, explain how an investor could potentially mitigate his risk.

Aug 13th, 2015

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  • Risks associated with Bonds                                                                                                                           Credit Risk -   The risk that a bond's issuer will go into default before a bond reaches maturity.                 Market Risk - The risk that a bond's value will fluctuate with changing market conditions.                     Interest Rate Risk - The risk that a bond's price will fall with rising interest rates.                                     Inflation Risk - The risk that a bond's total return will not outpace inflation.                                                      Re-investment Risk-The risk that the proceeds from a bond will be reinvested at a lower rate than the bond originally provided. 
The most well-known risk which investor should be cautious  is Interest Rate Risk -  Its the risk that bond prices will fall as interest rates rise. By buying a bond, the bondholder has committed to receiving a fixed rate of return for a fixed period. Should the market interest rate rise from the date of the bond's purchase, the bond's price will fall accordingly. The bond will then be trading at a discount to reflect the lower return that an investor will make on the bond.
                              

             Mitigation of the Risk

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Aug 13th, 2015

  Mitigation of the Risk

  • Falling interest rates often result in higher stock valuations and lower bond prices, and vice versa for rising interest rates.   The following are solutions.                                                                                                                                         
Buy Interest Rate Futures – Sophisticated investors can purchase futures contracts on government bonds  or interest rate futures. These trades enable them to lock-in a certain interest rate and hedge their portfolios.                          
 Sell Long-term Bonds – Many individual investors hedge against rising interest rates by selling bonds, which tend to see their prices fall as yields rise, particularly in bonds with long maturities and low coupon rates.                Buy Floating-Rate or High Yield Bonds – Many individual investors also hedge against rising rates by                transitioning their bond portfolios from long-term to short-term bonds.
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Aug 13th, 2015

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