Structure of Interest Rates

Risk investing

  • Risk - is an uncertainty with respect to your investments that has the potential to negatively affect your financial welfare.

    In short, risk is:

    • the possibility that you will not profit on the investment

    • The possibility that you will not be able to recover the amount you paid to acquire the investment

  • It is possible that the issuer will fail to uphold his commitment

  • This failure may be due to factors beyond the issuer’s control, such as an economic recession or downfall

  • It may be also because the issuer’s business fails and goes bankrupt

  • No security is truly risk-free

  • Accordingly, investor behavior depends a lot on how much risk they wish to assume

Investor behavior is typically one of three strategies:

  1. Conservative - investors hates risk and prefer to invest in safer or less risky securities

  2. Moderate - investor is willing to take risk, but only to a moderate degree

  3. Aggressive - investor is willing to assume a lot of risk and invest in many risky securities

  • An important phrase to remember is HIGH RISK, HIGH REWARD

  • An investor needs to be convinced that the security is worth the risk

  • When it comes to debt securities, a common incentive is to offer higher interest rates

Factors Affecting Interest Rates

  • issuers will offer prices (interest rates) that compensate for the risk. High risk, high reward

The following risks can be considered to affect interest rates:

  1. Inflation

    • Is not really a risk, but is included because it is a very basic consideration when designing an attractive security

    • Refers to a general increase in the prices of goods and services in an economy

    • This means that money becomes less valuable because it can buy fewer things. For example, Php20 today might buy more than Php20 will in a few years.

    • To make up for this, lenders charge interest so that they can recover the lost value from inflation. The same is true for investments. Investors won't lend their money unless they receive an interest rate that at least covers inflation.

    • Treasury bills are short-term debt securities issued by the government. There is almost no way that the government would fail to return the initial investment to an investor, because the government is the largest and most stable entity in any country

  2. Credit risk or Default risk

    • It is simply the risk that the issuer of the debt fails to pay the debt on time.

    • The due date of a debt is called the maturity date.

    • The failure to pay a debt on time is known as defaulting

    • It is especially relevant for longer term securities

    • To protect themselves, lenders often charge higher interest rates when they think the borrower has a higher chance of defaulting

    • The higher the credit risk, the more interest a lender will demand to cover that risk.

  3. Liquidity

    • In finance and accounting, something is liquid when it is easily convertible to cash

    • is the chance that you might not be able to sell an investment or turn it into cash quickly when you need to without losing money

    • In investing, some assets, like stocks of big companies, can be sold quickly because there are always many buyers and sellers. These are "liquid" investments. But other assets, like certain bonds or real estate, might take longer to sell, which creates liquidity risk.

There are 2 risks relating to liquidity:

  • The risk that the issuer is not liquid. This means that the company (or issuer) might not have enough cash on hand, so it's looking to raise money from investors

  • Risk that the security itself is not liquid. This refers to how easily you can sell the investment (or security) to someone else. If an investment is "not liquid," it means it’s hard to sell and turn into cash.

  1. Tax Status

    • Income earned from securities can still be subjected to tax

    • Even though a security pays, say 10,000 in interest income, the investor has to pay some of it to the government

    • is the chance that changes in tax laws could affect the value of an investment.

  2. Term to Maturity

    • is the amount of time before the maturity date.

    • The due date on the debt security (that is, when the principal will be fully repaired) is called the maturity date

    • refers to the amount of time left until an investment, like a bond, is fully repaid.

    • It's the period between when the investment is made and when the borrower (like a company or government) is supposed to pay back the full amount of the loan.