Risk Measurement Tools & its Types
Risk Measurement Tools
INTRODUCTION: Bonds though not as risky as stocks, are not completely risk less. There are certain risks associated with bonds. These risks have to be measured before a risk management strategy is prepared.
TYPES OF RISK: The following are the types of risks associated with the bonds:
1. Price risk: This is the degree of change in the price daily and is a blend of default risk and interest rate risk.
a) Default risk: It is the risk which arises when the issuer is not able to satisfy the terms and conditions of the obligation with respect to the timely payment of interest and repayment of the amount borrowed. If a default occurs, the investor does not lose the entire amount invested. A certain percentage of the investment can be recovered. This is called recovery rate. The percentage of a population of bonds that is expected to default is called default rate. Given the default rate and the recovery rate, the estimated expected loss due to a default can be computed.
b) Interest rate risk: It is known that the price of a typical bond changes in the opposite direction with a change in interest rates or yields i.e., when interest rates rise, a bond’s price will fall; and when interest rates fall, a bond’s price will rise. Since the price of a bond fluctuates with market interest rates, the risk that an investor faces is that the price of a bond held in a portfolio will decline if market interest rates rise. This risk is referred to as interest rate risk and is the major risk faced by the investors in the bond market.
2. Call Risk: In a callable bond, the investor faces the inconvenience of getting the bonds called back by the issuer in case of falling interest rates in the market. This option gives the issuer the opportunity to pay the debts before maturity date. Especially in the falling interest rate periods, the issuer uses this option as he can get funds at the cheaper rate. Normally the issuers will fix a call premium to protect the investor to some extent; also callable bonds will be normally offered at slightly higher rates as compared to normal bonds.
3. Reinvestment Risk: At falling interest rate periods, the investor cannot reinvest at the same interest rates at which the earlier incomes were reinvested. In these situations, zero – coupon bonds are at an advantageous position as far as investors are concerned as the incomes are reinvested by the issuer. The higher the coupon on the bond, higher the reinvestment risk since the investors may go in for speculative investments.
4. Marketability risk: This is due to the non – marketability of bonds as most of them are not traded in the secondary markets. This happens in the case of low rated bonds. For these bonds, the investor may have to lose substantially while selling them as the buyers expect a higher premium. The degree of sensitivity of a bond’s price to changes in market interest rates (i.e., a bond’s interest rate risk) depends on various features of the issue, such as maturity, coupon rate and embedded options.
a) Impact of maturity: All other factors remaining constant, the longer the bond’s maturity, the greater the bond’s price sensitivity to changes in interest rates.
b) Impact of coupon rate: All other factors remaining constant, the lower the coupon rate, the greater the bond’s price sensitivity to changes in interest rates.
c) Impact of embedded options: The value of a bond that contains embedded options will change depending on how the value of the embedded options changes when interest rate changes. The price of a callable bond can be decomposed as follows:
Price of a callable bond = (Price of option-free bond) – (Price of embedded call option)
HEDGING: Corporates issue bonds with varying options and with varied maturities. With the increase in the bond market worldwide, it is necessary to protect the investors from the risks associated with bond market worldwide, it is necessary to protect the investors from the risk associated with bond price volatility, movements in interest rates, changing spreads, etc.
Fixed income securities like bonds also face risks. These risks are with respect to inflation, interest rates, etc. Therefore, the bond holders have to protect themselves from risks by using hedging strategies. A good hedging strategy should have the following components:
1. Identification of the factors responsible for the volatility of the prices.
2. Measurement of acceptable price volatility.
3. Selecting a hedging instrument as per the requirement.
4. Estimating the maximum position in the hedge instrument.
5. Analysis of the hedging strategy to arrive at the cost and its effectiveness.
TYPES OF HEDGING INSTRUMENTS: There are different types of hedging instruments which are in use for the corporate securities. They are:
1. Cash market securities: Treasury securities are mostly used for hedging in the cash market as they do not have credit risk or bonding risk, these are normally taken as hedge instruments.
2. Futures contracts: Treasury futures are traded and widely used. These contracts are the most liquid ones. Treasury future contracts because of their several options of timing and maturity have complicated pricing. Treasury futures are supposed to have physical delivery on due date. Hence, the seller delivers any one of the securities within the given time. This results in futures contract going for Cheapest To Delivery (CTD) against the contract. Normally low duration securities tend to be CTD when rates are on the higher side.
3. Interest rate swap: Different borrowers have different borrowing requirements. To be more specific, some borrowers such as manufacturing companies normally prefer fixed rate borrowing. On the other hand, financial market players such as banks often need floating rate funding. In addition, often a borrowing entity wants to access the market where it does not have a comparative advantage. Under such conditions, an interest rate swap can be used profitably.
