Basics of Corporate Finance

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.

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