Question

-Briefly describe the types of risk faced by investors in domestic bonds. Indicate the additional risks associated with nondomestic bonds.

Answer 1

1) Inflation risk

Inflation, or price inflation is the general rise in the price of various commodities, products, and services that we consume. Inflation erodes the purchasing power of the money.

2)Liquidity risk

Investments in fixed income asset are usually considered less risky than equity.Even within
that, government securities are considered the safest. In order to avail the full benefits of the
investments, or to earn the promised returns, there is a condition attached. The investment
must be held till maturity. In case if one needs liquidity, there could be some charges or such
an option may not be available at all.

3) credit risk

When someone lends money to a borrower, the borrower commits to repay the principal as
well as pay the interest as per the agreed schedule. The same applies in case of a debenture
or a bond or a fixed deposit. In case of these instruments, the issuer of the instruments is the
borrower, whereas the investor is the lender. The issuer agrees to pay the interest and repay
the principal as per an agreed schedule. There are three possibilities in such arrangements:
(1) the issuer honors all commitments in time, (2) the issuer pays the dues, but with some
delay, and (3) the issuer does not pay principal and the interest at all. While the first is the
desirable situation, the latter two are not. Credit risk is all about the possibility that the second
or the third situation may arise.