Compare Long-Term Instruments And Short-Term Risks ✓ Solved

Compare long-term instruments and short-term risks, in terms

There will be two discussion questions listed below. Respond to one of the discussion questions and submit your response to the Discussion Area. Use the lessons and vocabulary found in the reading. Support your answers with examples and research and cite your sources using APA format.

Discussion Question 1: Compare long-term instruments and short-term risks, in terms of the various types of risk to which investors are exposed. Justify your answer.

Discussion Question 2: What methods can be used by the FED to influence interest rates? Are these methods effective? Use examples where appropriate.

Start reviewing and responding to at least two of your classmates' postings as early in the week as possible. Participate in the discussion by asking a question, providing a statement of clarification, providing a point of view with a rationale, challenging an aspect of the discussion, or indicating a relationship between one or more lines of reasoning in the discussion.

Paper For Above Instructions

In the world of finance, understanding the risks associated with long-term and short-term investment instruments is crucial for making informed decisions. Investors face various risks that can affect their returns, and it is essential to differentiate these risks based on the maturity of the financial instruments they choose. This paper will explore the types of risks linked to long-term and short-term instruments, highlighting the distinctions that can guide investment strategies.

Types of Risks Associated with Long-Term Instruments

Long-term instruments, often defined as investments with maturities exceeding one year, include bonds, stocks, real estate, and mutual funds. These instruments generally expose investors to several risks:

• Interest Rate Risk: Long-term investments are particularly sensitive to shifts in interest rates. When interest rates rise, the market value of existing bonds usually declines. Conversely, when rates fall, existing bond values increase. Therefore, long-term investors must contend with the potential uncertainty of future interest rate movements (Choudhry, 2019).
• Inflation Risk: Inflation erodes purchasing power, making it essential for long-term investors to consider the inflation-adjusted returns of their investments. If a long-term investment does not yield returns that adequately outpace inflation, the investor's real returns could be negative (Mankiw, 2021).
• Default Risk: This risk, more pronounced in bonds, revolves around the potential for the issuer to fail to make interest or principal payments. Long-term bondholders must evaluate the issuer's creditworthiness consistently (Fabozzi, 2020).
• Market Risk: The value of long-term investments, especially equities, can be significantly impacted by broader market movements. Economic downturns or geopolitical issues can lead to declines in stock prices, affecting long-term capital gains (Bodie, Kane, & Marcus, 2014).

Types of Risks Associated with Short-Term Instruments

Short-term instruments, generally defined as having maturities of one year or less, include treasury bills, commercial paper, and certificates of deposit. The risks associated with these instruments differ:

• Liquidity Risk: Short-term investments may face liquidity challenges if investors need to sell quickly. While many short-term instruments are relatively liquid, certain factors may affect their marketability (Bodie et al., 2014).
• Reinvestment Risk: Upon maturity, there is a risk that the returns from short-term instruments may not be reinvested at the same rate of return, especially if market rates decline (Mishkin, 2020).
• Credit Risk: Although considered lower for short-term instruments, credit risk still persists, particularly in commercial paper and corporate bonds. Assessing the creditworthiness of issuers remains crucial (Friedman & Schwartz, 1963).

Comparing Long-Term and Short-Term Risks

The essential difference between long-term and short-term risks lies in their exposure to various factors affecting returns and capital preservation. Long-term instruments are more sensitive to economic cycles and interest rate fluctuations, whereas short-term instruments, while relatively stable, face unique risks related to liquidity and reinvestment (Choudhry, 2019; Bodie et al., 2014).

Investors pursuing long-term strategies must be prepared to weather market volatility and economic shifts, while short-term investors can escape some of these risks but may confront challenges in maintaining liquidity and securing favorable reinvestment opportunities (Mankiw, 2021; Mishkin, 2020).

Conclusion

Choosing between long-term and short-term instruments involves understanding the respective risks tied to each option. Long-term investments offer potential for growth but entail higher exposure to interest rate and market risks. In contrast, short-term investments provide greater liquidity and lower volatility but carry risks concerning reinvestment and liquidity. Investors need to align their investment choices with their financial goals, risk tolerance, and market conditions.

References

• Bodie, Z., Kane, A., & Marcus, A. J. (2014). Investments (10th ed.). McGraw-Hill Education.
• Choudhry, M. (2019). Bond and Money Markets: Strategy, Trading, Analysis. Wiley.
• Fabozzi, F. J. (2020). Handbook of Fixed-Income Securities (8th ed.). McGraw-Hill Education.
• Friedman, M., & Schwartz, A. J. (1963). A Monetary History of the United States, 1867-1960. Princeton University Press.
• Mankiw, N. G. (2021). Principles of Economics (9th ed.). Cengage Learning.
• Mishkin, F. S. (2020). The Economics of Money, Banking, and Financial Markets (12th ed.). Pearson.