Government, corporate and equity markets

Question 1

Describe government bond market and properties

Answer 1

• Issuing government bonds is the main way in which government finance fiscal deficit
• The demands of purchasers can influence the terms on which debt is issued
  o For example, there has been a high demand for long dated bonds given the
  increasing use of annuities for pension funds
• Government bonds issued by developed countries:
  o are very secure, low risk form of debt and
  o suitable for matching guaranteed payments arising from selling annuity business
• As issues are large, marketability tends to be good
• Fixed interest rates will expose investors to inflation risk

Question 2

Types of risks associated with corporate bond markets and expected returns

Answer 2

• Expose investors to
  o Default risk
  o inflation risk
  o marketability risk – less marketable than government bonds
  o liquidity risk – less liquid than government bonds
• Premiums are featured into the market price of bonds (the spread which looks at the
  difference between the yield on corporate bonds compared with equivalent government
  bonds)
  o Expected returns of corporate bonds will be higher but
  o The actual return will be based on experience
• Investors that intend on holding the bonds to maturity , will not be concerned with
  marketability and liquidity , the return associated with the two will therefore be a pure
  reward to investor

Question 3

Types of risks associated with equity markets

Answer 3

• Equities expose investors to
  o Default
  o marketability,
  o liquidity risk and
  o the risk of uncertain dividend payment stream and resale price
• Equity is a real investment ( protects against inflation risk in the long run)
• Largely influenced by the contagion risk ( driven by market sentiments )
  o A fall in the US Equity markets is likely to trigger falls in the worldwide equity market

Question 4

Guarantees and investment choices

Answer 4

• Financial products generally offer guarantees and to ensure that customers are
  disadvantaged
• regulators require providers to hold capital against guarantees
• If the provider can demonstrate that the assets held are a good match for guarantees
  offered, the capital required t be held as a buffer against poor experiences can be lower
• The level of matching and mismatching will be influenced by
  o the risk appetite of the provider which is driven by the free capital it has available
  o the greater the level of free assets available, the greater the scope the provider has
  to depart from well-matched position