It is commonly argued that fewer risk factors (as compared to the stock market) explain expected...

It is commonly argued that fewer risk factors (as compared to the stock market) explain expected returns in bonds. Indicate the main risk factors that empirical studies on the performance evaluation of bond funds consider and explain the risks they aim to capture.

Expert Solution

Answer: Bond Fund- It is the type of debt fund that primarily invest into debt securities, Government bonds, municipal bonds and mortgage backed securities.

Risk factors in Bond funds- These are the risk triggers associated with bonds and bond funds-

Interest rate risk- Bond funds are exposed to interest rate risk, interest rates have inverse relationship with bonds, when interest rate rises, price of bond falls. Interest rate fluctuations affect the price of bonds.

Credit risk- This risk shows that the bond issuer may fail to repayment of principal of bond. This is also called default risk that is default in repaying the principal.

Rating risk- Bonds are provided with credit ratings based on their repayment capacity, risk and return. Bonds that provide higher return and repays the principal on time, are awarded with AAA+, AAA, AA-. Bonds with lower ratings are less attractive.

Exchange rate risk- Forex risk is associated with foreign bond funds and international bond funds.

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