What is Interest Rate Risk?

Interest rate risk is an indicator that addresses the potential for the value of an asset to decrease because of unforeseen interest rate changes. For example, if interest rates rise, the value of bonds or other fixed-income investments in the secondary market falls. Given the changes in interest rates, the change in the price of a bond is known as its duration.

Interest rate risk can be reduced by purchasing bonds at different times, by hedging and many effective methods. This article will cover interest rate risk meaning, its types, how to reduce it, and more. This will help you to get more knowledge about the concept and further may lead to mitigating this risk in your portfolio.

Key Highlights 

• Interest rate risk meaning, indicates that the potential asset might lose its value due to fluctuations in interest rates.

• The two main types of interest rate risk are price risk, where bond prices fluctuate, and reinvestment risk, where reinvestment opportunities may not match the original investment’s return.

• Factors like loan duration, market conditions, credit risk, and foreign exchange rates, can influence how interest rate changes impact investments.

• Interest rate risk can be managed through diversification of bond portfolios and hedging techniques.

Understanding Interest Rate Risk 

Interest rate risk is the probability of decreasing an asset’s value because of changes taking place in the interest rate in the economy. The interest rate risk definition addresses that this risk affects debt instruments like corporate bonds, government bonds and other fixed-income securities. While their price won’t be tied to share market sentiment, they tend to be affected by the interest rate changes directly.

Bond and debt tool costs are inversely correlated with interest rates. So, if the interest rates increase, the bond value falls. Conversely, if the interest rates decline, bonds might experience an upward trend in value. 

For fixed-income securities, as interest rates rise, the value of these fixed-income securities declines, and vice versa. This is because when the interest rate grows, the opportunity value of holding these securities will increase, and more people tend to invest in them. The interest rates earned on these securities consequently have much less appeal as interest rates rise.

Therefore, bondholders are suggested to monitor interest rate trends and changes to make knowledgeable selections of bonds and other fixed-income securities.

Example of Interest Rate Risk

Existing traders with older bonds can miss out on better interest payouts from the newly issued bonds. This makes older bonds with decreased interest rates less attractive to buyers. Consequently, the share marketplace values of such bonds fall. Let’s understand “what is interest rate risk” more clearly with a simple example.

Let’s assume that a person named ABC is maintaining a government bond worth Rs. 1,00,000 from an old point of time, that pays interest at 8% per annum. So, the value of the invested amount of Rs. 1,00,000 with the addition of 8% would rise to Rs. 1,08,000 in 12 months.

Now, consider that due to rising interest rates, the government is offering an interest rate of 9% per annum on newly issued bonds. So, Rs. 1,00,000 worth of these new bonds will increase upward to Rs. 1,09,000 in a year. In this manner, ABC lost out on Rs. 1,000 during the year due to the low interest rates on bond holdings.

Types of Interest Rate Risk

The following is the breakdown of types of interest rate risk:

1. Price Risk

Price risk refers to the risks of changes in the price of an investment bond or fixed-income securities. As a result, when the security is sold in the future, there will be unforeseen losses or profits.

2. Reinvestment Risk

Reinvestment risk is a part of interest rate risk that happens when you are not able to reinvest your money on the same return as your original funding. For example, consider that you are holding a bond that can pay a potentially high interest rate, and it is about to mature. At this point, if the prevailing interest rates have declined, you might need to reinvest the proceeds at a lower interest rate.

Factors that Affect Interest Rate Risk

The following is the breakdown of several factors that affect interest rate risk:

1. Loan Duration

Typically, the longer the period of a loan, the more it’s it is affected by the interest rates. Since bonds are usually debt that is offered by the bondholders to the bond issuers, long-term period bonds are more likely to be affected by the change in interest rates. This is why even a 1-2% increase in interest rates leads to a significant impact on bonds that are meant to mature after a long period. So, the interest rate risk is potentially much for long-term period bondholders.

2. Market-associated Factors

Many share market-related factors also affect the change in interest rates of debt and other related instruments. This includes factors like the regulations of the Reserve Bank of India (RBI) and the wide market sentiment. Inflationary pressures also are tied to the interest rate risk. If you’re making plans to put money into debt funds or debt instruments, you may need to consider these factors for effective results.

3. Credit Risk

Credit risk measures the probability that a borrower will default on a loan amount. Increased credit risk results in higher interest rates because lenders will aim to offset increased default risk by charging interest rates. This will increase borrowing costs and reduce bond prices. Thus, when a firm’s credit rating falls, its bond also price falls as investors begin to expect higher returns to compensate for the increased risk.

4. Forex Rates

Forex rates are exchange rates between different currencies. This generally affects the value of bonds issued by international debt companies. It also affects international lending and investment. Higher interest rates can increase the value of the currency. This further affects the value of foreign investment. Moreover, any adverse change in forex rates can also increase interest rate risks.

How To Mitigate Interest Rate Risk?

As with other types of risks, the interest rate risk can also be mitigated. The most common instruments to reduce interest rates are as follows:

1. Hedging

Several hedging techniques can help reduce interest rate risk. Generally speaking, one of these techniques involves buying various derivatives. Common forms include forward rate agreements (FRAs), options, futures, and interest rate swaps.

2. Diversification

Suppose the bondholder fears his portfolio will suffer from the risk of interest rate fluctuations that could negatively affect its value. In that case, he can diversify it by adding securities whose valuation is less susceptible to volatility in interest rates. When an investor owns only a portfolio of bonds, it is possible to diversify the portfolio by mixing short and long-term bond portfolios.

Conclusion

Interest rate risks are fairly manageable through using strategies like purchasing bonds at different times or using hedging techniques. Risk management concerning interest rates involves looking at the potential loss on business or individual portfolios due to rate fluctuations in the financial market. If interest rates increase, the value of investment in fixed income and bonds will decrease on the secondary market. As a result, the existing bonds will be subject to a price fall, offsetting the new high rates. Understanding this concept is important for making informed investment decisions and protecting your assets from unexpected changes in interest rates.

FAQs on Interest Rate Risk