The risk of value depreciation of bonds and other fixed-income investments is known as interest rate risk. Primarily due to depreciation in their interest rates, this happens because of market fluctuations. Such risk affects many types of investments, though it primarily affects fixed-income investments like bonds and certificates.
Typically, with a rise in the interest rate of a bond or certificate, there is a fall in the price of all related securities. Additionally, opportunity cost increases too, along with a rise in their interest rate. Defined as the cost of missing out on better investment options, this opportunity cost is directly proportional to the interest rate risk.
Bonds and certificates, which have lower maturity tenure, generally carry a lower risk of devaluation due to a rise in interest rates. Usually, when a newly issued security offers better returns, investors shift from their existing investments to the new options. While existing securities can only compete with the new releases by dropping their price, effectively getting devalued.
Like an interest rate risk example, consider that Mr. Daljeet invests Rs. 10,000 on bonds of value Rs. 100 each. These securities offer a fixed return of 5% per annum. In a 1-year period, the total value of an investment would be as follows.
10,000 + (5/100)10,000
= 10,000 + 500
Now, if the interest rate on newly issued securities is offered at 6% per annum, the total revenue on this investment after a year would be as below.
10,000 + (6/100)10,000
= 10,000 + 600
As it shows, Mr. Daljeet misses out on Rs. 100 when the interest rate offered on fixed securities increases to 6% since his financial assets are tied to a bond which offers a lesser return. As a result, it can be expected that Mr. Daljeet would re-invest his financial assets from his older investment to the newly issued securities with better returns. This risk of devaluation of a bond due to an increase in its interest rate is known as the interest rate risk.
There are quite a few types of interest rate risks, which must be noted by every investor, be it an individual or a firm. These are explained below in detail.
The risk of change in the price of an investment bond or certificate is known as its price risk. This leads to unforeseen losses or gains while selling security in the future.
The risk of change in their interest rate might lead to the selling of the securities. In turn, this can lead to a loss of opportunity to re-invest in the current interest rate. Known as reinvestment risk, these types of interest rate risk can be further divided into 2 categories.
|Duration risk||Risk due to the probability of unwillingness to extend an investment beyond its maturity period.|
|Basis risk||Risk of being subjected to a negative downturn in the market.|
There are many factors, which directly impact the interest rate risk associated with a company. These factors are discussed below in detail.
It is important to learn how to manage interest rate risk since it can potentially make an institution dysfunctional and ultimately bankrupt. The few methods which can be employed to manage the interest rate and in turn associated risks are discussed below.
|1.||Forwards||The simplest of strategies to combat interest rate risks, this option is the fundamental one on which many other strategies have been formulated. The basic idea behind this management method is to make a specific trade or exchange agreement under the given circumstances though the exchange is to be scheduled for a future date.|
|2.||Forward Rate Agreements||As suggested by the name, forward rate agreements are a type of forwarding where the interest rate which is applicable decides the gain or loss. In these types of agreements for interest rate management, one of the involved parties offer fixed interest rates in exchange for floating interest rates which are equal to reference rates.|
|3.||Swaps||Much like the name and what it suggests, this method which is often used to manage risks related to interest rates is quite similar to Forwarding rate agreements. Here, the 2 parties involved in an agreement swap the interest rates.|
|4.||Futures||Very similar to forwarding contracts, this method of managing interest rate risk involves an intermediary. Typically, the default is lessened in this method. Additionally, the liquidity risk involved in these agreements is much lesser than those of forwards.|
It is important for investors to note the above risk management options since risks related to interest rates can greatly affect a company or an investor. As evident from the interest rate risk example mentioned above in this article, managing the risk is necessary to prevent the devaluation of any investment security.
Investors who primarily invest in securities like bonds and certificates are mostly affected by interest rate risks since these are interest rate is inversely proportional to the value of a security.
Equity investors are usually indirectly affected by interest rate risks. The value of stocks is not affected by interest rate stocks directly, however, it often impacts the financial condition of companies which can, in turn, affect the share prices.
Yes, all the assets of a financial institution are affected since the value of existing securities and the expected cash flow change with interest rate risk.