What Is The Relationship Between Risk And Return ...

Published Oct 27, 20
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Required Rate Of Return Definition

When it comes to investing, what is the typical relationship between risk and return?

Duration risk is the modified duration of a bond is a measure of its price sensitivity to interest rates movements, based on the average time to maturity of its interest and principal cash flows. Duration enables investor to more easily compare bonds with different maturities and coupon rates by creating a simple rule: with every percentage change in interest rates, the bond’s value will decline by its modified duration, stated as a percentage.

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Bond portfolio managers increase average duration when they expect rates to decline, to get the most benefit, and decrease average duration when they expect rates to rise, so minimize the negative impact. If rates move in a direction contrary to their expectations, they lose. When interest rates rise, bond prices fall; conversely, when rates decline, bond prices rise. .

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When interest rates are declining, investors have to reinvest their interest income and any return of principal, whether scheduled or unscheduled, at lower prevailing rates. Inflation causes tomorrow’s dollar to be worth less than today’s; in other words, it reduces the purchasing power of a bond investor’s future interest payments and principal, collectively known as “cash flows.” Inflation also leads to higher interest rates, which in turn leads to lower bond prices.

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The risk that the bond market as a whole would decline, bringing the value of individual securities down with it regardless of their fundamental characteristics. The risk that an investor chooses a security that underperforms the market for reasons that cannot be anticipated. The risk that an investment performs poorly after its purchase or better after its sale.

A bond is an "IOU" for money loaned by an investor to the bond's issuer. In return for the use of that money, the issuer agrees to pay interest to the investor at a stated rate known as the "coupon rate." At the end of an agreed-upon time period when the bond "matures" the issuer repays the investor's principal.



They also provide investors with a steady income stream, usually at a higher rate than money market investments. Zero-coupon bonds and Treasury bills are exceptions: The interest income is deducted from their purchase price and the investor then receives the full face value of the bond at maturity. All bonds carry some degree of "credit risk," or the risk that the bond issuer may default on one or more payments before the bond reaches maturity.

When It Comes To Investing, What Is The Typical Relationship ...What Is The Relationship Between Risk And Return ...

To help measure credit risk, many bonds are rated by independent entities such as Moody's and Standard & Poor's (S&P). Ratings run from Aaa (Moody's) or AAA (S&P) through D (for default), based on the rater's appraisal of the issuer's creditworthiness. Aaa (Moody's) and AAA (S&P) are the highest credit ratings.

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Footnote 1 They may be appropriate for investors who can withstand higher price volatility and default risk while seeking increased investment cash flow potential. Like stocks, all bonds can present the risk of price fluctuation (or "market risk") to an investor who is unable to hold them until the maturity date (when the original principal amount is repaid to the bondholder) - Risk and Return.

An inverse relationship: Interest rate risk Another risk common to all bonds is interest-rate risk. In normal circumstances, when market interest rate levels rise, existing bonds' market values usually drop (and vice versa), although past performance does not assure future results. However, interest rate risk's effect on market value may be a relatively minor factor for income-oriented, buy-and-hold investment strategies - .

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