Question

Your company intend to issue a bond fund in this season, which it comprises of variety of bonds. Your colleagues have identified the risk factors in relation to this bond issuance such as liquidity risk, interest rate risk, market risk, credit risk and currency risk. Suggest and explain on how the risk management strategies work in managing the risks posed to the fund.

Answer 1

To manage the interest rate risk of a bond, a bond holder should hold the bond till maturity.

Interest rate risk is the risk that the bond price changes with the changes in the interest rates. As the interest rate falls, the bond price rises and as the interest rate rises the bond prices fall.

Security selection :To minimize the impact of credit risk, which is the risk that the bond holder defaults on the principal and interest payments. The bond holder should buy the US government bonds or bonds with higher ratings as the investment grade bonds. Liquidity risk is the risk that the bonds cannot be easily sold in the market. High yield bonds are less liquid, so the investor should invest in the investment grade bonds

Market risks comprise of the currency risk, it is the risk that the value of the bond may fall due to the currency fluctuations. To manage this risk, we can hedge the bond portfolio by using the appropriate financial hedging  instruments like futures and forwards.

So, these risk management strategies mentioned above helps to manage and even eliminate the risk posed to the fund.