Interest Rate Risk
Interest rate risk is the potential for investment losses due to changes in interest rates, particularly affecting fixed-income securities like bonds whose prices fall when rates rise.
🎬 Video Explanation
Exam Tip
Rates UP = Bond prices DOWN. Longer duration = more interest rate risk.
What is Interest Rate Risk?
Interest rate risk is the risk that changes in interest rates will negatively affect the value of an investment. It primarily impacts bonds and other fixed-income securities.
How It Works
When interest rates RISE:
- Bond prices FALL
- New bonds offer higher yields
- Existing bonds become less attractive
When interest rates FALL:
- Bond prices RISE
- New bonds offer lower yields
- Existing bonds become more attractive
Factors Affecting Interest Rate Risk
| Factor | Impact |
|---|---|
| Maturity (Duration) | Longer = More risk |
| Coupon Rate | Lower = More risk |
| Credit Quality | Lower quality = Less rate sensitivity |
Duration
Duration measures a bond's sensitivity to interest rate changes:
| Duration | Rate Change | Price Impact |
|---|---|---|
| 5 years | +1% | -5% price |
| 10 years | +1% | -10% price |
| 20 years | +1% | -20% price |
Managing Interest Rate Risk
- Ladder bonds - Spread maturities over time
- Shorter duration - Less sensitive to rate changes
- Floating rate securities - Rates adjust with market
- Diversification - Include various fixed income types
- TIPS - Inflation-protected treasuries
Who Faces Interest Rate Risk?
| Investor Type | Risk Level |
|---|---|
| Bond investors | High |
| Preferred stock holders | Moderate |
| Utility stock investors | Moderate |
| Banks/Financial institutions | High |
| Retirees relying on fixed income | High |
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Bond
A bond is a fixed-income debt security where the issuer owes the holder a debt and pays interest (coupon) plus principal at maturity.
Duration
Duration is a measure of a bond's price sensitivity to interest rate changes, expressed in years. A higher duration means greater price volatility when interest rates change.
Yield
Yield is the income return on an investment, expressed as a percentage, including interest or dividends received.
Inflation
Inflation is the rate at which the general level of prices for goods and services rises over time, decreasing the purchasing power of money.
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