Skip to 0 minutes and 19 secondsA bond is a contract in which a corporation, a government, or another party, in return for a loan, promises to pay back the principal at a future date, and to pay interest on the loan at specified future dates. The main risk of a bond is that the bond issuer might not fulfil its commitment to pay interest and principal. This is the default risk. If the issuer of the bond defaults on its payment obligations, the owner of the bond will lose part of his or her investment. There is also another risk associated with bonds. Bonds are tradable securities, which means that they can be bought or sold on the financial markets.

Skip to 1 minute and 4 secondsThe price at which an existing bond can be bought or sold depends on the conditions at which comparable new bonds are issued. The main factor that determines the price of bonds is the rate of interest which is paid on the loan. If the rate of interest increases, the price of existing bonds will decline. Hence, bondholders would face capital losses if there is an increase in interest rates. The market value of their bonds will fall. On the other hand, if interest rates increase, then bondholders stand to make capital gains.

Skip to 1 minute and 46 secondsWhen you buy equity - a stock or a share issued by a company - you put money into the company in return for the promise to receive a share in the value of the company. The value of the company itself will depend on its expected future profits. You may receive payments in the form of dividends. But since your shares can be traded on the stock market, you could also make gains if the market value of your shares increases. This could happen, for instance, when there is positive news on the company. Unlike bonds, as a rule, your equity does not entitle you to a guaranteed stream of payments. The returns on your equity can therefore be highly uncertain.

Skip to 2 minutes and 32 secondsIf a company goes bankrupt, you may even stand to lose a large proportion of your investment. In general, then, investment in equity can be risky, because there is no guarantee of future payments, and the price of stocks can go up or down and the value of your investment could therefore also be subject to large variations.

Skip to 2 minutes and 57 secondsA number of indexes have been developed around the world to measure how the average value of stocks changes. In the United States, one of the most common stock market indexes is the Dow Jones Industrial Average, known simply as "the Dow." The Dow was invented in 1896, and now records an average of 30 significant stocks that are traded in the New York Stock Exchange and in the NASDAQ, which is a more recent stock exchange that specialises in technology and biotech companies. Another important indicator for the United States is the Standard & Poor's 500 Index. This includes the stocks of the 500 largest corporations in the New York Stock Exchange and in the NASDAQ.

Skip to 3 minutes and 47 secondsAll large stock exchanges in the world have their own indexes of average stock prices. For the United Kingdom, the best-known index is the FTSE 100, which includes the largest corporations traded in the London Stock Exchange. The FTSE 250 also comprises smaller companies. Other important stock market indexes are the Nikkei 225 for the Tokyo Stock Exchange in Japan, the Hang Seng Index for the Hong Kong Exchange, and the DAX Index for the Frankfurt Exchange in Germany.

Skip to 4 minutes and 32 secondsThere are a number of volatility indexes which measure the degree of uncertainty in stock markets. The best known of these is the VIX, which is calculated by the Chicago Board Options Exchange. The VIX measures the market's expectation of stock market volatility over the next 30-day period. It is computed from the market prices of financial options, which we'll study in week 3.

What are the risks of bonds and equities?

All investments come with a level of risk, but how can we deal with the risks associated with bonds and equities?

In this video, Prof Pasquale Scaramozzino outlines the main features of bonds and equities and explains how investors monitor their performance.

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This video is from the free online course:

Risk Management in the Global Economy

SOAS University of London