Inflation Risks: Interest rates are defined in nominal terms. This means that they express the rate of exchange between current and future rupees. For example, a nominal interest of 12 percent on a one year loan means that Rs 112 is payable a year hence for Rs 100 borrowed today. However, what really matters is the real rate of interest, the rate of exchange between current and future goods and services.
Since financial contracts are typically stated in nominal terms, the real interest rate should be adjusted for the expected inflation. According to the Fisher effect, the following relationship holds between the nominal rate r, the real rate a, and the expected inflation rate, α
(1+ r) = (1+ a) (1+ α)
r = a + α + aα
For example, if the required real rate is 6 percent and the expected inflation rate is eight percent, the nominal rate will be:
(0.06) + (0.08) + (0.6) (0.08) = 0.1448 or 14.48 percent
With the inflation is higher than expected, the borrower gains at the expense of the lender and vice versa. Put differently, inflation is a zero sum game.
The impact of a change in inflation rate is similar to that of a change in interest rate. This means that inflation risk is greater for long term bonds. Hence, in a period of volatile inflation rates, borrowers will be disinclined to issue long term fixed interest bonds and investors too, will be reluctant to buy such shares. During such time, floating rate bonds and shorter maturity bonds become more popular.
Real Interest rate Risk: Even if there is no inflation risk, borrowers and lenders are still exposed to the risk of change in the real interest rate. Shifts in supply and/or demand for funds will change the real rate of interest.
To understand the implication of real interest rate risks consider an example. Suppose that the real interest rate falls from 6 to 4 percent because a combination of tax law changes and heightened competition drives down the real interest rate. In this case a firm that has borrowed funds at six percent real interest rate suffers. While it now earns only four percent on its assets, it has to pay six percent on its debt. Irrespective of whether it gains or loses from a change in the real estate of interest, a firm that has locked itself into a long term debt at a fixed real cost can experience a dramatic impact whenever the real rate of interest changes. As such changes can scarcely be predicted they represent a source of risk that borrowers and lenders have to face.
Default Risk: Default risk refers to the risk accruing from the fact that a borrower may not pay interest and/or principal on time.
Other things being equal bonds which carry a higher default risk (lower credit rating) trade at a higher yield to maturity. Put differently, they sell at a lower price compared to governmental securities which are considered free from default risk (as the government has the power to print money, it is believed that it will not default in honoring its commitments).
Except in the case of highly risk debt instruments, referred to as junk bonds, investors seem to be more concerned with the perceived risk of default rather than the actual occurrence of default. Even though the actual default may be highly unlikely, they believe that a change in the perceived default risk of a bond would have an immediate impact on its market price.
Call Risk: a bond may have a call provision that gives the issuer the option to call the bond before its scheduled maturity. The issuer would generally exercise the call option when the interest rates decline. While this is attractive from the issuer’s point of view, it exposes the investors to call risk. Since bonds are typically called for prepayment after interest rates have fallen, investors will not find comparable investment vehicles. They almost invariably have to accept a lower yield when they invest the amount received on premature redemption.–