FINANCIAL
MARKETS AND INTEREST RATES 2-9
Liquidity risk
Liquidity refers to the marketability of assets the ease with which
assets can be sold for cash on short notice at a fair price. Investors
may require a premium return on an asset to compensate for a lack of
liquidity. For example, there are active world markets in which
investors holding bonds issued by Ford Motor Company can easily
sell the bonds and receive cash within a matter of seconds. On the
other hand, an investor who has loaned money to a small Honduran
trading company will have a much more difficult time finding another
investor in the secondary market to purchase the loan.
The Honduran trading company pays a higher interest rate for its
borrowings than does Ford (all other factors being equal) because
its securities are harder to sell in the secondary market.
Interest rate
risk
As interest rates fluctuate, so do the prices of bonds in the secondary
markets. We will discuss this relationship between interest rates and
bonds in more detail later in the course. For now, you need to know
how a change in rates affects bond prices.
·
As interest rates increase, bond prices
decrease.
·
As interest rates decrease, bond prices
increase.
After an interest rate increase, newly issued bonds yield larger
interest payments than older bonds. The price of old bonds falls to
attractive levels so that investors will continue to buy them. Older
bonds are priced in the market so that the rate of return paid on the
investment is approximately the same as other investment
opportunities with similar risk and maturity.
All long-term bonds carry interest rate risk because there is more
opportunity for interest rates to rise. For this reason, investors often
require a risk premium in the stated interest rate. The net effect of
this premium is to raise rates on long-term bonds relative to the
rates on short-term bonds.