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Risk and Return Structure

This document discusses different types of bonds and their risk levels. It also compares government bonds to corporate bonds. The main types of bonds discussed are supranational bonds issued by organizations like the IMF, national bonds issued by governments, and corporate bonds issued by companies. Government bonds generally have the lowest risk, while corporate bonds have the highest risk. The document also states that bond prices are inversely related to interest rates - as interest rates increase, bond prices decrease. When comparing government bonds to corporate bonds of the same maturity, government bonds have lower default and liquidity risk as well as being tax-exempt, making them less risky than corporate bonds. Finally, the example shows how risk premiums make government bonds

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Naeem Khan
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51 views

Risk and Return Structure

This document discusses different types of bonds and their risk levels. It also compares government bonds to corporate bonds. The main types of bonds discussed are supranational bonds issued by organizations like the IMF, national bonds issued by governments, and corporate bonds issued by companies. Government bonds generally have the lowest risk, while corporate bonds have the highest risk. The document also states that bond prices are inversely related to interest rates - as interest rates increase, bond prices decrease. When comparing government bonds to corporate bonds of the same maturity, government bonds have lower default and liquidity risk as well as being tax-exempt, making them less risky than corporate bonds. Finally, the example shows how risk premiums make government bonds

Uploaded by

Naeem Khan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Risk and Term Structure of Interest Rate

TYPES OF BONDS AND ISSUANCE


Supranational Issued by IMF, World Bank In a way by providing loan to the country
National Issued by Government Municipal Bonds, T-Bills, Having Less Risk
State Issued by Sindh, Punjab and other provinces In order to complete certain
Projects having Less Risk
Corporate Bonds Issued by Corporates Having High Risk as compare to others

Relationship of Interest rate and bond

Interest Rate is Inversely Proportional to all bonds, Whenever Interest rate is increased the prices
of Bonds will decreased

Comparison of Government Bonds and Corporate Bonds


Bonds having same maturity means time to complete the bonds having different interest rate
(return)
• Bonds with the same maturity have different interest rates due to:
 Default risk :- low in Government bonds and High in Corporate bonds
 Liquidity Risk:- low in Government bonds and High in Corporate bonds
 Tax considerations:- No Tax in Government Bonds and Tax on Corporate Bonds

Coupon Rate = Interest rate bonds prices are same in government bond and corporate bond
Coupon Rate > Interest rate so Government security will be sold at discount means 100 ka
bond 98 pe sell hoga
Coupon Rate < Interest Rate so Government Security will be sold at Premium 100 ka bond
110 pe sell hoga
Government Bonds
Price is 100 and Coupon rate on the basis on Interest rate like now it is 13.25
For example in corporate bonds Price is 100 and Coupon rate on the basis on Interest rate like
now it is 13.25
We chose Government bonds because
• Default risk low in Government bonds and High in Corporate bonds
• Liquidity Risk low in Government bonds and High in Corporate bonds
• Tax considerations No Tax in Government Bonds and Tax on Corporate
Bonds
Example of risk in Government Bonds and Corporate Bonds as shows below
and explained
Government Bond Price 100 and Risk free rate is 10% means 10% return milai ga and yield to
maturity is 1 year means aik saal tak 10% milai ga and corporate bond has price 100 and internal
rate of return is 10% and yield to maturity is 1 year means ager kisi month me interest rate change
huwa tu return bhi change ho sakta hai 12% bhi ho sakta hai and 5% bhi ho sakta hai measn risk
ziada hai so. We buy government bonds because it has low risk and fixed return

Risk Premium Shows the Corporate bonds return may fluctuate so we buy government securities
having fixed return.
• Mainland.com that issues one-year, corporate bond, price =$100 and provide return or
coupon 4%
• Suppose risk-free rate is 4% on government bond for 1 year calculate price of risk free
bond means government bonds

$4  $100 $104
P   $100
1.04 1.04

• Yield is return on government bond 104/100-1= 4% risk rate and return are same here.

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