Sunday 26th December, 2004

 

Interest rate risk

 
 
 
 
 
 
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Money Matters
with Raziah Ahmed

Just about three quarters of the world's 6.2 billion people live in "developing" countries, surviving on a mere one quarter of the world's total income. In fact, the poorest 20 per cent of the world's population earn 0.5 per cent of the world's income, and the richest 20 per cent, earn 79 per cent of all world income. And as the old cliché goes: the rich get richer!

Today we continue our discussion on investment risk. Risk in this scenario is properly defined as "the chance that the actual outcome from an investment will vary from the expected outcome."

Last week we saw that some time ago, a bond had been recalled on the local market. The perceived risk was thus not the experience of those investors who were prevented from earning what they had calculated. In fact, the experience was worse that what was expected.

This type of risk is the major risk faced by bondholders, and it is called "interest rate risk." The market was paying a lower interest rate on other types of securities, than was promised to the bondholder, and the bondholder exercised his option to "call in" the bond. The capital was returned to the participants.

The bond issuer promptly announced a new bond issue at a lower rate of return. Ours being a small and a limited market, investors (mostly the same participants) promptly bought up the bonds, for a lower rate of return.

Interest rates were the source of the risk.

There are other sources of risk: inflation risk, liquidity risk, and exchange rate risk, to name a few. Inflation risk is the risk that the money you invest will not have the purchasing power in the future as it has today. Inflation risk is usually related to interest rate risk, and interest rates generally rise as inflation increases.

For those of us looking forward to rising interest rates, as the economy "picks up" we must look as well for its economic partner in trade: rising inflation. If inflation is to be managed, then interest rates will not rise significantly, in the typical course.

Liquidity dilemma

Liquidity is the ability to easily convert an asset into cash. Many persons invest in real estate, and find themselves in retirement, with an inadequate pension cheque. Their dilemma is compounded when they can't sell off the asset for fair market value. Many widows and heirs to estates, sell off assets cheaply, in order to convert them into cash, because too much in accumulated in the estate as "property" and not enough though was given to the "cash flow" situation of the survivors.

Exchange rate risk is the way returns/ income varies as a result of fluctuations in currency value. Persons, who save money in foreign currency, participate in the global currency market. Persons, who invest only in local stocks, in local currency, do not face exchange rate risk.

With respect to the types of investment vehicles, so far we have looked at mutual funds, and bonds. Stocks are another alternative. A stock certificate gives the holder ownership interests; the owner is said to have "equity" in the organisation. Certain rights are allowed this owner e.g. voting rights at annual general meetings.

Stocks are more risky than mutual funds and bonds. The stockowner has what is called a "residual claim." In other words, a stock claim will only be paid after all bond obligations have been settled.

In general, organisation issue bonds or stocks to raise money to initiate or continue projects. They take money from the richest 20 per cent of the world's population, and issue "securities." Such investors have more to gain when the securities earn huge dividends. And the rich get richer, as the night follows the day.

n Raziah Ahmed is a Registered Financial Consultant

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