[MUSIC] Hi again. So we just saw in the previous video that government bonds have many merits. After this video you will be able to identify the main risks which there are in investing in bonds, and we will also give you some highlights as to how to hedge against these risks. But this will come in the later part of these courses. There are five main risks in investing with government bonds. The first is economical risk. The second is political risk. Then there is interest rate risk. And we will make a link here with the previous video. You remember the rule and the glasses and how they fell apart. So we'll see how duration comes into play when we talk about interest rate risk. Then there's inflation risk, and last but not least, we're going to talk about currency risk. So let's start with economical risk. We said that governments are safe, in that normally, they do not default. They're always able to pay back the debt that they've issued in the form of government bonds. But in some cases, Actually, they do default, and there's been many historical examples of these defaults. I told you that government bonds first came into existence in Greece. Greece has been a country which has defaulted on its debt. Including very recently. Other examples include Latin American countries who regularly, countries like Argentina, who have regularly defaulted on their debts. So in principle, we may say that governments when they face difficulties, ie they cannot finance all their expenditures, they can actually raise taxes to collect more money, more revenues to finance their expenditures. The problem is that if they do that, investors will demand a higher interest rate. They will see that the government has difficulties, and so the next time they come and they issue a bond, investor will be reluctant to invest in these bonds so the government will have to come with higher interest rates. So basically when we talk about economic risk we're talking about the probability that the government will default. This probability is low, but it's not zero. So indeed, there is that risk. Then there is the political risk. It's related but a bit different than the previous one, economic risk, economical risk. Here the government will also kind of default, will not pay back its debt. But here it's a political decision. So in the first example, economical risk. The government is unable to pay back the debt. Here it is able but it is unwilling. So we have a historical example of this. For instance, Russia at the beginning of last century and also in 1998. We had the so-called Russian Crisis. And here it's a combination of economical and political risk, in that the government devalued the currency, the Rouble. It faces economic difficulty so they said basically let's devalue the currency in an effort to boost exports and revive growth in the economy and also they defaulted on the debt. So here we do have also this risk that basically you don't get your money back because the government refuses to give your money back. Okay, the third risk that we're going to have a look at is interest rate risk. Basically, we saw that there is this inverse relationship between the interest rate, the yield, yield to maturity and the price of a bond. We gave you the example and let's have a look at it again. If you hold a bond and it's yielding 10%, and then suddenly a new bond comes into existence about 12% we saw in the previous video how this would depress the price of the bond yielding 10% basically so that the yields match between the old bond and the new bonds. So basically while interest may go up, the price of the bond comes down. And now we can make the link with the famous concept of duration which we saw. You remember this number of year which equlibrates all the cash flow. All the revenues you get year after year investing in bonds and the principle. You know the big bottle at the end. Duration is a kind of point where all the cash flows and the principle are in balance. It's also a key concept because it measured the sensitivity of the bond to movements in interest rates. And this can be seen in the following formula. So, we can see from this formula, and we wanted to illustrate with this formula how the interest rate risk is captured by duration. So we see it here that the percent changes in the price of an asset, such as a bond, is actually equal to -D and D stands for duration, times, and you see this formula in brackets, delta R and delta R is the change in interest rates. Divided by 1 + r, and that's where we're standing in terms of interest rates. So this may look a bit complicated. Apologies for this, but you will see how it's very clear. We have a numerical example. So let's assume that D, the duration, is 6.55, okay? And let's assume further that we have a coupon rate of 10% and the price of bond is at par at 100. Now, let's assume that the interest rate, the yield, which is 10%, goes from 10 to 12%. So, how will this affect the bond price? Well, we have the formula here so we substitute in there, D for 6.55. Then the changes in interest rates, it goes from 10% to 12% so it's an increase by 2%, 2 percentage points. So it's actually 0.02, and it's divided by the initial level of the interest rate, so that's 10%. So it's 1 + 0.1, 1.1. And all this boils down, translated into percentage, so you multiply by 100 to get percentage changes, and you see that it's -11.91. So actually it's a huge increase. Can you believe it? I mean interest rate goes from 10 to 12%, but the price of your investment, how much your bond is worth, it actually drops by almost 12%, duration is a key metric, because here it measures the sensitivity of your bond to changes in interest rates. We took the example here of 655, but let's assume that the bond duration was not 655, but say ten, we would have had a bigger drop in the bond price. So, duration is actually a key metric where you have to hedge against and manage the interest rate risk of your bond or a bond portfolio. Okay, so this was the first risk, we saw economical, political risk, interest rate risk, now let's talk about inflation risk. We have here this nice picture of your wallet being squeezed. Being squeezed by what? By purchasing power being lowered by the fact that when you get your money back from the government, you get your capital, your principal, back. If there's been lots of inflation in between, then your money is worth less. So to illustrate this, let's assume that you bought a bond and it gives you a coupon of $100 each year over ten years. And then suddenly after three years we get an unexpected price jump, unexpected increase in inflation, right? Okay, so if a new bond comes into existence it will reflect these conditions of higher inflation. But you holding this old bond does not reflect this higher inflation. Interest rates will have to go up to compensate for this higher inflation rate. And so the value of your bond will go down, because the investors in the new bond when they will look at you say, hey, but your $100 as coupon is worth less because of inflation and so the price of your bond will fall. In other words, other investor will only accept to buy the bond if you give them a discount. So it's basically the same kind of impact as when interest rates go up. Here, it's inflation which goes up and decreases the real value of your bond. Okay, now let's have a look at the last, but not least, risk. This is currency risk. We said, when we first talked about government bonds, that these are issued by governments. And traditionally, typically, they're issued in domestic currency. but obviously these bonds are accessible to foreign investors. So if I'm a Swiss investor, or French investor and my base currency is euro or Swiss franc, and I buy a US dollar bond, and if the dollar goes down versus the euro or the Swiss franc, then when I get my money back, my principle, I may have gained this regular stream of income year after year. But when I get my money back and the dollar has fallen in between, then I can make a loss. And this could be quite substantial because currencies are actually, can be actually quite volatile. So for the moment we are just identify these risk, we identified five of them, but it will be at a later stage that we will show you how we can hedge against these risks. So stay tuned. [MUSIC]
