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 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 increase 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.
Types of Interest Rate Risks
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.
- Price risk
The risk of change in the price of an investment bond or certificate is known as its price risk. This leads to unforeseen loss or gains while selling security in the future.
- Reinvestment risk
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.|
Factors Impacting Interest Rate Risks of a Firm
There are many factors, which directly impact the interest rate risk associated with a company. These factors are discussed below in detail.
- Credit risk associated with a company: A company’s debt to equity ratio is one of the primary determinants of credit risk. A rise in interest rates leads to more expense for a company since they have to pay more interest to its investors. As a result, the credit risk of an institution increases.
- Length of loan terms: Length of loan terms, both as a borrower as well as a lender, are major determinants of the interest rate risks of an institution. Companies and ventures charging a fixed interest on its receivable accounts might have baselines dropping down if they need to refinance themselves. This, in turn, increases the risk involved with the shift in interest rates.
- Market fluctuation: Market fluctuation and inflation can immensely impact the risk related to interest rates since refinancing, or other such necessities can become more difficult during such times. Such circumstances often lead to a situation where outgoing cash flow crosses the incoming cash flow, making it more difficult for the institution to function.
- Foreign exchange rates: Any company which has a foreign debt is also affected by a change in foreign exchange rates. The associated interest rate risks increase with fall in the price of the prevalent currency, while the inverse happens in case there is a rise in the price of the currency.
How to Manage Interest Rate Risks?
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.
- Diversification: Among the different options that can be employed by an institution to manage the interest rate risk associated with them, one of the most effective options is to diversify their financial investments. For investors who invest in both equity and fixed investment options, this is the best method to manage the risks associated with interest rates.
- Safer investments: The safest option for investors who are trying to reduce the risks associated with interest rates is to invest in bonds and certificates, which have short maturity tenure. Securities with short maturity tenure are less susceptible to the fluctuations in interest rate. This method for interest rate management reduces the chance of being subjected to interest rate fluctuations since they have low maturity tenure.
- Hedging: Hedging is an option, which can be used successfully to reduce the risks related to interest rates. Generally referring to the purchase of various types of derivatives which are available, there are many ways of hedging. A few of the hedging strategies are illustrated in the table 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.|
- Selling long-term bonds: A common method which is often used is that of selling the long-term bonds. This effectively clears up the investment funds for re-investment in bonds with higher returns, thus allowing investors to manage the interest rate risk better. It is advisable to re-invest in securities which have shorter maturity tenure since these carry lesser risks related to interest rates.
- Purchasing floating-rate bonds: Floating rate bonds, as suggested by its name, have a rate of interest, which is directly related to market fluctuations. It is advisable to invest in these securities since being related to the market fluctuations, the return on these investments go up and down too. These should also be bought in a healthy mix of long-term and short-term investments. While this cannot always be used to calculate the exact return, it is helpful in reducing the interest rate risk involved.
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. 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.
- Which types of investors are most affected by interest rate risks?
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.
- Are equity investors affected by interest rate risks?
Equity investors are usually indirectly affected by interest rate risks. The value of stocks are not affected by interest rate stocks directly, however, it often impacts the financial condition of companies which can, in turn, affect the share prices.
- Does interest rate risk impact the non-financial assets of a financial institution?
Yes, all the assets of a financial institution are affected since the value of existing securities and the expected cash flow changes with interest rate risk.