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Financial Risk Management. Types of risks. Credit Risk. Risk that the issuer will not make scheduled payments. The higher the risk of negative credit event (default, etc), the higher the interest rate investors will demand for assuming that risk.
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Credit Risk Risk that the issuer will not make scheduled payments. The higher the risk of negative credit event (default, etc), the higher the interest rate investors will demand for assuming that risk. •Private rating agencies (Moody’s and Standard & Poor’s) provide guidance for investors to the credit quality of various issues.
Credit Risk Short Term: It is the relative credit risk of obligations with an original maturity not exceeding thirteen months. Long Term: It is the relative credit risk of obligations with anoriginal maturity of more than one year (in practice about 3 years horizon)
Credit risk Credit spread = difference between the yields on a “default able” corporate bonds and a US government bond of comparable maturity. • Spreads between interest rates on various private and public sector debt contain valuable information • Spreads widen during recession and contract during economic expansion • Contracting spreads is a positive sign for markets/economy • Looking for default risk changes and liquidity changes in the market • Different ways to compare short-term vs. long-term interest rate/inflation expectations
Credit risk Credit Default Swaps: A huge market with over $40 trillion of notional principal Buyer of the instrument acquires protection from the seller against a default by a particular company or country (the reference entity) Example: Buyer pays a premium of 90 bps per year for $100 million of 5-year protection against company X Premium is known as the credit default spread. It is paid for life of contract or until default If there is a default, the buyer has the right to sell bonds with a face value of $100 million issued by company X for $100 million (Several bonds are typically deliverable)
Liquidity risk • Liquidity risk is concerned with an investor having to sell a bond below its indicated value, the indication having come from a recent transaction. • Liquidity refers to how deep or liquid the market is for a particular security. If the market is deep, an investor can purchase or sell a security at current prices. If the market is not liquid, it is harder to sell or buy a security at the last market price. • Liquidity is typically measured by the bid/ask spread. If the spread is wide, the market is illiquid. If the spread is narrow, the market is more liquid.
Liquidity risk Liquidity risk is important because it tells you how easily you can get rid of a position if you need to close it near the last market price. This is even more important if you plan to hold a security to maturity because of the marking to market of your positions. In an illiquid market, it may be hard to obtain quotes, and when you revalue the security it could be well below market prices, affecting the reports you send to clients and management.
