interest rate risk

Examples of interest rate risk in the following topics:

• Price Risk

  • Price risk is the risk that the market price of a bond will fall, usually due to a rise in the market interest rate.
  • Bond price risk is closely related to fluctuations in interest rates.
  • Fixed-rate bonds are subject to interest rate risk, meaning that their market prices will decrease in value when the generally prevailing interest rates rise.
  • However, because of the interest rate risk, bonds with longer terms are more risky than bonds with shorter terms.
  • As with interest rate risk, this risk does not affect the bond's interest payments (provided the issuer does not actually default), but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.

• The Interest Rate Risk

  • Interest rates became volatile during the 1980s, forcing banks to become more concerned with interest-rate risk.
  • Banks experience an interest-rate risk, when changes in the interest rates cause the banks' profit to fluctuate.
  • If the interest-rate sensitive liabilities exceed the interest-rate sensitive assets, then rising interest rates cause banks' profits to plummet, while falling interest rates cause banks' profits to increase.
  • If the interest-rate sensitive liabilities equal the interest-rate sensitive assets, then fluctuating interest rates do not affect bank profits.
  • If the interest rate rises, subsequently, the banks increase the interest rate on the loans.

• Comparing Price Risk and Reinvestment Risk

  • Price risk is positively correlated to changes in interest rates, while reinvestment risk is inversely correlated.
  • To sum up, price risk and interest rates are positively correlated.
  • Reinvestment risk and interest rates are inversely correlated.
  • In summary, price risk and reinvestment risk are two main financial risks resulting from changes in interest rates.
  • The former is positively correlated to interest rates, while reinvestment risk is inversely correlated to fluctuations in interest rates.

• Disadvantages of Bonds

  • Bonds are subject to risks such as the interest rate risk, prepayment risk, credit risk, reinvestment risk, and liquidity risk.
  • Fixed rate bonds are subject to interest rate risk, meaning that their market prices will decrease in value when the generally prevailing interest rates rise.
  • When the market interest rate rises, the market price of bonds will fall, reflecting the ability of investors to get a higher interest rate on their money elsewhere — perhaps by purchasing a newly issued bond that already features the newly higher interest rate.
  • If there is any chance a holder of individual bonds may need to sell his bonds and "cash out", the interest rate risk could become a real problem.
  • As with interest rate risk, this risk does not affect the bond's interest payments (provided the issuer does not actually default), but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.

• Reinvestment Risk

  • The risk resulting from the fact that interest or dividends earned from an investment may not be able to be reinvested in such a way that they earn the same rate of return as the invested funds that generated them.
  • Reinvestment risk is more likely when interest rates are declining.
  • For example, falling interest rates may prevent bond coupon payments from earning the same rate of return as the original bond.
  • Especially with the short-term nature of cash investments, there is always the risk that future proceeds will have to be reinvested at a lower interest rate.
  • Interest rate on the bond - The higher the interest rate, the bigger the coupon payments that have to be reinvested, and, consequently, the reinvestment risk.

• Measuring Country Risk

  • International investors, buying foreign bonds, can experience a currency exchange rate risk, an interest-rate risk, a borrower default, and/or a country risk.
  • For an interest-rate risk, investors observe the interest rate rises as the bond's market price falls.
  • Investors protect themselves from credit risk by increasing the borrower's interest rate.
  • Consequently, the interest rate is comprised of the risk-free interest rate and risk premium.
  • Risk-free interest rate reflects the market interest rate with a zero default rate.

• Drivers of Market Interest Rates

  • Market interest rates are mostly driven by inflationary expectations, alternative investments, risk of investment, and liquidity preference.
  • A market interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender in the market.
  • In a free market there will be a positive interest rate.
  • The greater the risk is, the higher the market interest rate will get.
  • where in is the nominal interest rate on a given investment, ir is the risk-free return to capital, pe = inflationary expectations, i*n = the nominal interest rate on a short-term risk-free liquid bond (such as U.S.

• Types of Risk

  • There are many types of financial risk, including asset-backed, prepayment, interest rate, credit, liquidity, market, operational, foreign, and model risk.
  • Interest rate risk refers an asset whose terms can change over time, such as a Variable Rate Mortgage payment.
  • The mortgages often featured variable rate annuities, meaning that the interest rate terms of the mortgage started low and increased over time.
  • Buyers worried about an adjustment to their interest rate, and all of a sudden a 1500 monthly payment became 2000.
  • When interest rates climbed 2 percentage points and the mortgage climbed to $2000, some owners had to default (stop making payments) .

• Default Risk and Bond Price

  • Consequently, economists study these interest rates from these securities that they call the term structure of interest rates.
  • Economists call the difference between the interest rate on the U.S. government bonds and corporate bonds the default risk premium.Investors add default risk premium to a risk-free investment, so they can invest in "risky" bonds because they earn a greater return.
  • Consequently, corporations pay greater interest rates for their bonds while the U.S. government pays a lower interest rate.
  • Taking the difference between the government bond and corporate bond interest rates, we can calculate the risk premium.
  • Hence, the difference between government and corporate interest rates would widen.

• The Capital Asset Pricing Model

  • The current risk-free rate is 5%.
  • It determines what the rate of return of an asset will be, assuming it is to be added to an already well-diversified portfolio, given that asset's systematic risk.
  • Can lend and borrow unlimited amounts under the risk-free rate of interest.
  • The expected rate of return = the rate of return for a risk-free asset + beta* (the rate of return of the market - the risk-free rate).
  • The return of the market minus the risk-free rate is also known as the risk premium.