Interest rate risk definition
/What is Interest Rate Risk?
Interest rate risk is the possibility that the value of an investment will decline as the result of an unexpected change in interest rates. This risk is most commonly associated with an investment in a fixed-rate bond. When interest rates rise, the market value of the bond declines, since the rate being paid on the bond is now lower in relation to the current market rate. Consequently, investors will be less inclined to buy the bond; since demand declines, so too does the market price of the bond. This means that an investor holding such a bond would experience a capital loss. The loss is unrealized as long as the investor chooses to continue holding the bond, and will be realized once the bond is sold or reaches its maturity date.
Shorter-term bonds have a lower interest rate risk, since there is a shorter period of time within which changes in interest rates can adversely impact the bonds. Conversely, there is a higher interest rate risk associated with longer-term bonds, since there may be many years within which an adverse interest rate fluctuation can occur. Since longer-term bonds have a higher interest rate risk associated with them, their expected rate of return is typically higher than the rate on shorter-term bonds, which is known as the maturity risk premium.
When a bond has a higher level of interest rate risk, its price will fluctuate more when there is an adverse change in the interest rate.
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Example of Interest Rate Risk
An investor holds a bond that has a 4% stated interest rate, and which was purchased for $1,000. The market interest rate then climbs to 5%. Since bond buyers can now gain a better return elsewhere, the market value of the investor’s bond declines. In order to sell it, the investor would have to accept a price lower than $1,000, because the buyer would want to obtain an effective interest rate of 5%.
How to Reduce Interest Rate Risk
There are several ways to mitigate your interest rate risk. The most common methods are as follows:
Interest rate swaps. Exchange fixed-rate payments for floating-rate payments (or vice versa) to align with anticipated rate changes.
Forward rate agreements. Lock in an interest rate for a future borrowing or lending period, reducing exposure to rate fluctuations.
Interest rate caps and floors. Use derivative contracts to limit the maximum or minimum interest rate paid or received.
Duration management. Adjust the average maturity or duration of investment portfolios to reduce sensitivity to interest rate changes.
Diversification of debt instruments. Hold a mix of fixed-rate and variable-rate debt to balance interest rate exposure.
Hedging with treasury futures. Use futures contracts on government bonds to hedge against adverse rate movements.
Refinancing or restructuring debt. Modify debt terms (e.g., converting variable-rate debt to fixed-rate) to lock in favorable interest rates.
Asset-liability matching. Align the maturities of assets and liabilities to minimize mismatches caused by interest rate changes.