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MOVEMENTS
RUIZ, BEA FRITZ D.
BOND PRICE MOVEMENTS
• The
price of the bond should reflect the present value of future cash flows, based
on a required rate of return. Therefore, the higher the rate of return, the lower the
bond price is, and vice versa.
– Where:
• - price of a bond
• K – required rate of return per period used to discount a bond
GENERAL PRICE MOVEMENTS
• general price movements of the bonds can be modeled as:
– Where:
• - risk-free rate
• Rp – credit risk premium
FACTORS THAT AFFECT RISK-FREE RATE
•
• Strong Economic Growth tends to improve a firm’s cash flows and reduce the probability
that the firm will default on its debt payments
• Conversely, weak economic conditions tend to reduce a firm’s cash flows and increase the
probability that it will default on its bonds
IMPACT OF ISSUER-SPECIFIC
CHARACTERISTICS ON CREDIT RISK
• A bond’s price can also be affected by the factors specific to the issuer of the
bond, such as change in its capital structure.
• If a firm subsequently obtains additional loans, it may be less capable of making
its coupon payments and so its credit risk increases.
IMPLICATIONS FOR FINANCIAL INSTITUTIONS
• If they anticipate that the risk premiums of risky bonds will increase, they shift
toward relatively safe bonds that exhibit less credit risk.
• When they expect interest rates to rise, they sell bonds and use the proceeds to
purchase short-term securities that are less sensitive to interest rate movements.
SYSTEMIC RISK
• The potential collapse of the entire market of financial system.
• Some financial institutions use their investments in debt as collateral when
borrowing funds, but this collateral may no longer be acceptable during a credit
crisis
• Although theses securities could protect some participants during a credit crisis,
they can result in major losses for the counterparties
• Financial reform act of 2010