Interest Rate RiskDefined along with Examples

Written By:
Adiste Mae

What is Interest Rate Risk?

Interest Rate Risk is the probability of losses in investments from a decline in the value of assets due to a change in interest rates.

Fixed-income assets, such as bonds, are mostly associated with interest rate risk because the primary driver of a bond’s price is the interest rate. 

When the interest rates increase, the value of fixed-income assets will decline and vice versa.

Duration refers to the change in the price of a bond given an interest rate change. 

To reduce Interest Rate Risk, investors can diversify their existing portfolio by purchasing investments that are less prone to negative impacts due to interest rate fluctuations.

They can also reduce the risks by hedging their assets – purchasing different derivative types such as interest rate swaps, futures, forward rate agreements, or options. 

Understanding Interest Rate Risk

Interest Rates and Bond prices have an inverse relationship – when the interest rate rises, the value of bonds decreases (and vice versa).

This is because of the opportunity cost.

Opportunity cost can be defined as the benefit that would have been received if the other option was not chosen.

In the case of the relationship between interest rates and bond prices, when the interest rate increases, the opportunity cost of holding the bonds also increases. 

When an investor decides to purchase a bond, he or she has already assumed that should increase interest rates, he or she has given up the opportunity of owning other assets that offer more attractive returns.

Whenever there is an increase in interest rates, there is a corresponding decline in the demand for bonds with lower returns as bonds with higher returns are also issued. 

To better manage the risks associated with the fluctuation in interest rates, investors can decide to hedge or diversify their portfolio. 

Example of Interest Rate Risk

Say an investor purchases a 3-year, $1,000 bond with a 5% coupon.

After his or her purchase, the interest rate rises to 7%.

The increase in the rate will make it difficult for the investor to sell his or her bond especially when the market issues newer bonds that offer more attractive rates.

The decrease in the demand also lowers the price of the bonds in the secondary market and its market value may drop below the purchase price. 

Bond Price Sensitivity

Bond Price Sensitivity refers to the decline in varying degrees of the value of fixed-income securities of different maturity dates when the interest rates rise.

The Bond Price Sensitivity is measured by the duration of the bonds. 

For example, there are two fixed-income securities – one that will mature in 1 year and the other in 5 years.

When the interest rates increase and the value of the securities decline, both investors will have to endure the decrease of the market value of the securities that they are holding.

However, the investor holding the security that is maturing in 1 year has the option of reinvesting with a higher rate security while still holding onto the bond until it matures for another year.

But the other investor will have to suffer the decline of the value of his or her security for another 4 years. 

This example explains why longer-term securities have lower price value – the longer the maturity, the more its price declines when interest rates increase.  

The Maturity Risk Premium

Maturity Risk Premium is a way of compensating investors for taking in more risk from purchasing long-term bonds that are susceptible to changing interest rates over time.

The longer the term of these securities, the higher the interest rate risk.

This is why long-term securities have higher expected rates of return than short-term securities.