call risk
Definition of purchase risk
Purchase risk is the risk that the bond in which an investor has invested will be repaid by the issuer before its maturity date, thus increasing the risk for the investor because he would have to reinvest the amount repaid at a much lower rate or in an adverse investment market scenario.
Components of purchase risk
Purchase risk, as explained above, exposes an investor to an unfavourable environment. It has two main components
Candlestick Components
Call risk is often associated with callable
bonds which provide an option for the issuer to call the bond well before the maturity date. The likelihood of a bond being redeemed decreases over time, as there is less time left for the bond issuer to exercise the option to redeem the bond.
Candlestick Components
Interest rates are an even bigger factor in redemption risk because when interest rates fall, the yield rises and the issuer will find it advantageous to redeem the bond and restructure the bonds. bonds based on current trading cycles. leading to paying lower coupons for equal capital.
Important points
An investor invests in a bond because he wishes to obtain a fixed return for a fixed period. On the expiration date, when the horizon time has elapsed, the primary value is returned. This is a typical life cycle of a vanilla bond. However, the situation changes if the bond issued is callable. In such a scenario, the bond issuer has the right to call the bond, returning the principal to the investor well before the maturity date.
Although the investor gets his money back, he has to reinvest the principal amount to get the same quantum of return. This may not be possible as the market situation may be completely different. Most of the time, interest rates would be low. In economic terms, this is defined as reinvestment risk – the risk that reinvested capital will not yield the same returns as it was originally intended to yield.
The issuer of the callable bond must pay a premium on top of the coupon rate because investors must assume purchase risk and expect to be compensated for it.
In terms of calculation, the call risk payment is calculated in the same way as the call option, because the issuer may or may not redeem the bond.
Conclusion
The call risk as such is not a source of concern for the investor, but it is the beginning of many other unfavourable and unexpected situations. an unexpected drop in cash flow and therefore portfolio risk. Although handled properly, it can help a speculator earn good returns in a considerably short period.
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