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
Interest rate risk can be mitigated, either by diversifying your investments across a broad mix of security types, or by hedging. In the latter case, you can enter into an interest rate swap agreement with a third party, thereby offloading the risk of rate fluctuations onto the other party. However, the other party will charge a fee in exchange for taking on the associated interest rate risk (which essentially increases your interest expense or reduces your interest income).