Market Risk: from a market value perspective, the greater the investor’s risk aversion, the shorter the appropriate duration of the portfolio and the selected benchmark.
Income Risk: The longer the maturity of the portfolio and benchmark, the lower the income risk. Investors desiring a stable, long-term cash flow should invest in longer-term bonds and utilize long term benchmarks.
So, longer duration has HIGHER market risk and LOWER Income risk.
My question is: based on market risk, the greater the investor’s risk aversion, the shorter duration should be selected. However, based on income risk, the greater the investor’s risk aversion, the longer duration will be selected, right? If so, do these two concepts conflict with each other?
Thank you!
It depends on investors wish to be exposed to market risk or income risk. If investors prefer stable income, they should choose long duration portfolio.
you should know this by now…
JK just always wanted to say that to someone.
Anyways to your question… you have to look at it as 2 completely separate objectives that one might not happen because of the other. That’s why FI PMs utilize higher coupons on the longer end while using some zero coupons at the shorter end. Trying to reduce income risk at the same time reducing market risk.
For the most part you gotta remember 99% of the material isn’t wrong or cryptic, the answer is right there just gotta go into with it open mind and read it slowly and carefully. That’s the beauty of level 3, it’s all foundation and basics but when you talk to PMs all the time you start to see it all comes together like a puzzle
Thanks for the answers! I know. There a lot of things I should know by now but I just keep forgetting some of them. That is why I am trying to write all these things down now so that i can check them all the time.
Also, I agree with you I need to read slowly. I spent less than half of the time during previous two levels’ exams. Guess I have to slow down this time because of all these details. Thanks for the reminder and help!