Identify The Risks Of Holding Debt Securities. Analyze The Role(S) Of Debt Securities That Led To The Current Credit Crisis.

1427 words - 6 pages

According to the Hong Kong Exchanges and Clearing Limited, debt securities include bonds and notes which represent loans to an entity (such as a government, listed company or supranational organisation) in which the entity promises to repay the bondholders or note-holders the total amount borrowed at predetermined maturity date. The repayment in most cases is made on maturity although some loans are repayable in installments. Unlike shareholders, holders of bonds and notes are not owner of an entity, but its creditors. In return for the loan, the compensation for the bondholders or note-holders is interest payments during the life of the bond or note. The interest rate on bonds and notes can be a fixed, floating rate and zero-coupon. The debt securities offer periodical return with stable and predictable interest payments; however many investors may not realise that bonds carry certain degree of risks like equities.Interest rate risk: the risk of adverse movements in interest rates reducing the portfolio's value. There is an inverse relationship between changes in interest rates and bond prices. When interest rate goes up, bond price falls. The value of a bond is the sum total of the present value of its fixed future cash flows, discounted at the appropriate current market interest rate.Reinvestment risk: refers to callable bonds where the bond issuer has the right to "call" the bond before maturity and pay off the debt when interest rates fall. If investor uses the proceeds to reinvest in another bond, the rate is usually lower than the original rate. This kind of risk is more intense for those investors who depend on a bond's coupon payments for most part of their returns.Call and prepayment risk: the bond issuer can call a bond if the call price is below the market price due to falling interest rates. In this case, when interest rate declines, issuer can raise new funds at lower interest rates and able to repay the loans raised earlier under higher interest rates.Credit risk: risk of the loss that may occur if counterparty to a transaction fails to meet its obligations. This risk include three different type of risk, default risk, credit spread risk and downgrade risk. Default risk is the risk that a bond issuer will be unable to make interest or principal payments when they are due. Credit spread refers to the difference in yield between two issues that are identical in all respects except their credit ratings. Credit spreads are a function of the state of economy. During economic expansion, credit spreads decline as corporations are expected to have stronger cash flows during economic contractions. Cash flower are pressured which leads to a greater probability of default and increasing credit spread. Downgrade risk is the risk that a bond is reclassified as a riskier security by credit rating agency. The credit rating of a bond is an indicator of its quality. The bond is less likely to be default, the higher the credit rating it...

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