Earnings and business cycles have a very close relationship. Investors should, therefore, have a good understanding of the business cycle to make projections of earnings. Even then, it is worth noting that the effect of the business cycle on the…

Credit spreads vary across industrial sectors. When credit spreads are narrowing relative to government bonds, the spreads between higher- and lower-rated corporate bond categories also narrow. During these times, although corporate bonds generally outperform government bonds, lower-rated corporate bonds tend…

A credit spread is the difference in yield between a corporate bond and a government bond of equal maturity. Investors require the spread as a modality to compensate for the additional credit risk relative to that of government bonds. Besides…

The current value of a real default-free bond (inflation-adjusted) is given by: $$ P_0=\sum_{t=1}^{n}\frac{CF_t}{\left[1+R\right]^t} $$ For a default-free nominal coupon-paying bond (non-inflation adjusted), we have: $$ P_0=\sum_{t=1}^{n}\frac{CF_t}{\left[1+R+\theta+\pi\right]^t} $$ The difference between the yield on non-inflation adjusted (nominal) and inflation-indexed bonds…

Short-term Interest Rates and the Business Cycle Short-dated nominal zero-coupon government bonds have yields closely related to the central bank’s policy rate. Additionally, the uncertainty of inflation over the very short-term investment horizon, typically three months, is negligible. Therefore, the…

Real Default-free Interest Rates Consider an investor investing in a default-free bond. Further, assume that there is no inflation. The investor would still be entitled to compensation for not consuming today. This compensation is the opportunity cost of consuming today….

The return on any asset is determined by the expectation of future discount rate fluctuations. If interest rates are expected to fall, short-term investments will be less attractive while long-term investments will get more attractive. Longer-term bonds will continue to…

The market value of any asset is the sum of the present value of cash flows expected to be generated by the asset. Several factors determine the expected values of these cash flows. Some of these factors include the discount…

Capital allocation is critical to a firm’s market risk management. It involves setting limits on all activities and giving priority, in resource allocation, to areas expecting the greatest reward. When wisely allocating capital, a company ensures that all its risk…

Effective management of risk is highly dependent on designing suitable constraints that can be used in market risk management. Measuring VaR to a confidence level as high as 99% and placing a loose limit can be less of a constraint…