Earn your certification as a Financial Modeling & Valuation Analyst (FMVA)®. Register today!

Interest Rate Risk

The probability of a decline in the value of an asset resulting from unexpected fluctuations in the interest rate

What is Interest Rate Risk?

Interest rate risk is the probability of a decline in the value of an asset resulting from unexpected fluctuations in the interest rates. Interest rate risk is mostly associated with fixed-income assets (e.g., bonds) rather than equity. The interest rate is one of the primary drivers of a bond’s price.

 

Interest Rate Risk

 

 

The current interest rate and the price of a bond demonstrate an inverse relationship. In other words, when the interest rate increases, the price of a bond decreases.

 

Understanding Opportunity Risk

The inverse relationship between the interest rate and bond price can be explained by opportunity risk. By purchasing bonds, an investor assumes that if the interest rate increases, he or she will give up the opportunity of purchasing the bonds with more attractive returns. Whenever the interest rate increases, the demand for existing bonds with low returns declines as new investment opportunities arise (e.g., new bonds with higher returns are issued).

Although the prices of all bonds are affected by interest rate fluctuations, the magnitude of the changes varies among bonds. The rationale behind the fact is that different bonds show different price sensitivities to interest rate fluctuations. Thus, it is imperative to evaluate a bond’s duration while assessing the interest rate risk.

Generally, bonds with a shorter time to maturity carry a smaller interest rate risk compared to bonds with longer maturities. Long-term bonds imply a higher probability of interest rate changes. Therefore, they carry a higher interest rate risk.

 

How to Mitigate Interest Rate Risk?

Similar to other types of risks, the interest rate risk can be mitigated. The most common tools of interest rate mitigation include:

 

1. Diversification

If a bondholder is afraid of interest rate risk that can negatively affect the value of his portfolio, he can diversify his existing portfolio by adding securities whose value is less prone to the interest rate fluctuations (e.g., equity). If the investor is only interested in his bond portfolio, he can diversify his portfolio by including a mix of the short-term and long-term bonds.

 

2. Hedging

The interest rate risk can also be mitigated through various hedging strategies. The strategies generally include the purchase of different types of derivatives. The most common examples include interest rate swaps, options, futures, and forward rate agreements (FRAs).

 

More Resources

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Diversification
  • Floating Rate Note
  • LIBOR
  • Value at Risk (VAR)

Financial Analyst Training

Get world-class financial training with CFI’s online certified financial analyst training program!

Gain the confidence you need to move up the ladder in a high powered corporate finance career path.

 

Learn financial modeling and valuation in Excel the easy way, with step-by-step training.