Interest Rate Risk

What is Interest Rate Risk?

The term “interest rate risk” refers to the probability of a change in the value of fixed-income security owing to fluctuations in interest rates. Although the risk is due to any unexpected change in interest rate, the investors are predominantly concerned with the downside risk. The interest rate is one of the most critical drivers of the price of any fixed-income security. As such, it directly impacts the investors of fixed-income securities, such as when the interest rate goes up, the cost of fixed-income securities goes down and vice versa.

Explanation of Interest Rate Risk

The probability of value depreciation of fixed-income securities due to a change in interest rate is known as interest rate risk. Typically, a rise in the interest rate results in a decline in the price of the existing bonds and other fixed-income securities. Further, it also increases opportunity cost, which is the cost of missing out on other better investment options.

How to Manage Interest Rate Risk?

Some of the most common techniques used to manage it include:

• Diversification: Investors can diversify their portfolios by adding less affected securities by the fluctuations in interest rates. Examples of such diversification include investing in equities or creating a mix of long and short-term fixed-income securities.
• Hedging: Investors can also mitigate it by using various hedging strategies, including different derivatives. Some of the most common examples are options, future & forward contracts, interest rate swaps, etc.
• Invest in short-term securities: The investors can sell off long-term securities and clear up the funds for reinvestment in securities with higher returns. Then they can invest in securities with relatively shorter maturity tenure as these securities are less vulnerable to the volatilities in interest rate.
• Purchase of floating-rate bonds: As the name suggests, the interest rate of these bonds are floating in nature as they are directly linked to market fluctuations. In this way, investors can eliminate the risk of a change in investment value due to volatility in interest rates.

Example of Interest Rate Risk

Let us take the example of John Doe, who invested in 50 fixed-rate bonds worth $1,000 each. These fixed-income securities offer a return of 4% per annum to be paid at the time of maturity, which is one year from now.

Therefore, the total value of the investment at the end of one year can be calculated as,

• Total value = $1,000 * 50 + 4% * $1,000 * 50
• Total value = $50,000 + $2,000
• Total value = $52,000

Now, one week after the investment, John Doe knew that the interest rate on the newly issued securities went up to 5% per annum.

Therefore, had John Doe invested after one, the total value of the investment at the end of one year would have been,

• Total value _new = $1,000 * 50 + 5% * $1,000 * 50
• Total value _new = $50,000 + $2,500
• Total value _new = $52,500

Therefore, it can be seen that John Doe missed out on $500 of investment value as the interest rate offered on the newly issued fixed securities increased to 5%. In contrast, his investments are tied to securities with lower returns. As such, it can be expected that John Doe would be less inclined to continue with the old investment and would be interested in re-invest in the newly issued securities. This risk of depreciation of the value of securities due to an increase in interest rate is known as interest rate risk.

Types of Interest Rate Risk

It can be classified into two major types – price risk and reinvestment risk.

• Price risk: It refers to the risk of change in the value of the securities that may result in unexpected gains or losses at the time of its sale.
• Reinvestment risk: It refers to the inability to find favourable reinvestment opportunities due to a change in the interest rate. It is divided into two sub-parts –
  • Duration risk: It is the probability of involuntary prepayment or extension of the investment tenure beyond scheduled maturity.
  • Basis risk: It is the risk of imperfect hedging, i.e., the hedging strategy will fail to move in the opposite direction to the change in interest rate.

Sources

The primary sources of it are as follows:

• Repricing Risk: A primary source is the risk of repricing bank assets, liabilities, and off-balance sheet positions in the case of a floating rate.
• Yield Curve Risk: It arises due to unexpected shifts in the yield curve that adversely impact a bank’s income or underlying economic value.
• Basis Risk: It occurs due to an imperfect correlation between the rates paid and earned on different instruments with comparable repricing characteristics.
• Optionality: It arises from the options embedded in the bank assets, liabilities, and off-balance sheet positions.

Factors Impacting

The factors impacting it are as follows:

• Credit rating: Deterioration in the credit risk rating of the borrowers owing to various factors increases the interest rate being charged by the lenders, accentuating the interest rate risk.
• Economic outlook: During an economic downturn, companies face difficulties refinancing and borrowing new loans as the interest rates surge. The ambiguity surrounding cash inflow coupled with increased cash outflow due to higher interest rate increases the companies’ exposure to it.
• Foreign exchange rates: The growing strength of the domestic currency against other foreign currencies can adversely impact the borrowers’ interest rate risk if they pay interest on foreign currency debt.

Conclusion

So, it can be seen that it directly influences the cash flow of fixed-income securities. But not to worry, as there are many hedging tools available in the market that can mitigate this risk to a large extent.

Recommended Articles

This is a guide to Interest Rate Risk. Here we also discuss the introduction and how to manage it, along with types and examples. You may also have a look at the following articles to learn more –

1. Money Measurement Concept
2. Time vs Money
3. Money Market vs Capital Market
4. Money Market Account