Investment Risk Analysys

Week 1 Individual Assignment 1

Rachel Fleischaker

FIN420

Erik Steiner, AIU Adjunct Faculty

June 9, 2006

Introduction:

Selecting an investment takes time and some knowledge of the investment types available. You must have clearly defined investment goals, know which instruments will best meet those goals, and finally, how transactions to purchase and sell those instruments occur. In this document we will examine the following:

You have been asked to write a training document about the US Bond Market for use in the new employee training program. In your document, you must make sure to address each of the following:

1. the key players in the market; and the types of investments available to both individual investors and institutional investors,

2. the way transactions are carried out, and

3. the relation, if any, between the bond markets and the stock markets.

Analysis:

The first thing that must be defined is investment goals. Depending on investment goals, there are a variety of bond instruments available. Bonds, generally, are debt obligations used by the issuing entity to fund specific projects within the entity. These include municipal, corporate, government, mortgage-backed or asset-backed securities, and international bonds. Within each of the sectors listed, you find a variety of features Ð'- different issuers, varying yields and maturities, coupon rates, and risks as well as rewards.

Let us examine each of the various types of bonds, along with the associated risks and rewards. We will begin with municipal bonds.

Municipal bonds are debt obligations to cities, counties, states and agencies within governments used to fund specific projects like schools, roads, hospitals, sewer and water projects, and so on. The issuer promises to pay a specific interest payment at a specified time, usually semi-annually, with the principal to be repaid on a set maturity date. Not all municipal bonds are tax exempt, so the income from these may be taxed as income.

While the interest rate on bonds cannot change and is guaranteed to be paid, the market price on the bonds can change at the whims of the market. This means that if you sell your bonds prior to maturity, you will receive the market price for the bonds Ð'- which may be more or less than the original price.

Next, there are government bonds. Most of the bonds issued by our own federal government have interest payments that are tax exempt. When you purchase treasury instruments, T-bills, T-bonds, and T-notes, you are loaning money to your government for a specified time period with specified interest payments. These bonds carry the "full faith and credit" of the U.S. government. These are considered the safest of all investments.

There are many other types of bonds Ð'- corporate bonds, zero-coupon bonds, U.S. Treasury Inflation Protected Securities, government sponsored enterprise debt securities, high-yield bonds, and bond funds are just a few. These also have associated risks as well as the reward that is the guaranteed payment of interest for a specified time.

The risks are liquidity, interest rate, credit risk, and call risk. Liquidity risk is what occurs when the bonds do not trade well. If prevailing interest rates are higher than the coupon rate, investors are less likely to purchase the bonds. Additionally, if the issuer's credit rating falls, the bonds will be less desirable.

Bond prices rise when interest rates fall, and conversely, when interest rates rise, bond prices fall. If you must sell your bond before maturity in an environment where the interest rates are rising, you will probably receive less than you paid for it.

Credit risk means that the issuing entity may run into financial difficulties or declare bankruptcy and default on its obligation to repay the bonds or interest. The bondholders' obligation is entirely at risk if these things occur.

Call risk occurs when the instrument is callable prior to maturity. If the bonds are redeemed prior to maturity, the bondholder loses the interest from the redemption date to maturity.

There are several bond markets. The municipal securities market trades municipal bonds. The distinguishing feature of this market is the tax exemption provided for the interest received on many municipal bonds. This tax exemption does not apply to all municipal bonds, so if the goal of the investor is tax free income, some investigation must be done.

The treasury security market is the largest and most liquid market