What is interest rate risk and how does it work?

Interest rate risk is a silent force that can impact your life in many ways. Are you thinking of buying a house, starting your trading journey or taking a loan to begin your business? Then it’s important to understand what interest rate risk is and how it works. That’s because its impact is far-reaching, which can be from the cost of mortgage or even the overall performance of the stock market. Understanding what interest rate risk is will help you come up with interest rate risk management and hedging strategies.

What is interest rate risk?

Changes in interest rates can lead to a financial loss. It impacts fixed-income investments like bonds, where rising interest rates can decrease the value of existing bonds with lower interest rates. This risk also affects borrowing costs and corporate profitability, particularly for companies that have long-term debt or variable-rate loans.

It is important for traders to understand what interest rate risk is because interest rates represent the ‘price’ of money. It directly influences the attractiveness of different assets. Even a small shift in the interest rate can cause big market moves.

How interest rate risk affects traders and investors

Interest rate changes can cause market volatility. Unexpected shifts in monetary policy or economic indicators that signal interest rate changes can cause price swings in different asset classes. Staying abreast of this volatility can help you take advantage of opportunities and protect yourself from related risks.

Bond prices have a direct and inverse relationship with interest rate changes. When interest rates rise, bonds that have been recently issued offer higher yields. These new bonds make existing bonds with lower yields look less attractive to investors. So, the price of older bonds falls. On the other hand, when interest rates fall, existing bonds with higher yields become more popular. This causes an increase in their prices.

In the stock markets, higher interest rates increase borrowing costs for companies. This reduces their profitability and cause downward pressure on their stocks. Lower interest rates can stimulate economic activity and boost corporate earnings.

In the forex market, the difference in interest rates between two countries can impact the exchange rate of their respective currencies. A country with a higher interest rate attracts capital from those nations that have a lower interest rate. This causes an appreciation in the currency value of the country offering higher interest rates.

Central banks have the responsibility to decide the benchmark interest rates of their respective countries. They adjust the benchmark interest rates because they want to control inflation or stimulate economic growth. All banks set their interest rates accordingly.

Learn more about the factors that influence asset price moves with our market guides.

Examples of interest rate risk in action

Let’s look at the months between late 2022 and early 2023. During this time, central banks of the world’s biggest nations were increasing their interest rates in an attempt to cool off inflation. This led to a big selloff in the bond markets globally, as the value of existing bonds (with lower yields) declined. The stock markets also turned south because companies faced higher borrowing costs and there were recessionary fears.

Interest rate risk in bond investing

Imagine an investor purchases a 10-year bond with a 3% coupon rate. If, a year later, higher interest rates led to new 10-year bonds being issued with a 5% coupon rate, the original bond becomes less appealing. To sell that 3% coupon bond, the investor would have to lower its price significantly to offer a comparable yield to maturity as the new 5% bonds, resulting in a loss.

Impact of interest rate fluctuations on mortgage rates

For homeowners and prospective buyers, interest rate fluctuations directly translate to changes in mortgage rates. Higher rates potentially impact the affordability of homes. Conversely, falling interest rates can make mortgages more affordable, stimulating the housing market.

How to reduce interest rate risk?

If you are a trader, you will face this risk in any asset class you decide to trade. So, interest rate risk management strategies are very important. Let’s look at some things that you can do to reduce the risk.

Portfolio diversification

Diversification is a fundamental principle of risk management. By spreading investments across different asset classes and even within asset classes (short-term vs. long-term positions, different sectors), the overall impact of interest rate changes on your portfolio can be reduced.

Hedging strategies

There are multiple strategies for hedging interest rate risk. Interest rate swaps allow two parties to exchange interest rate payments, converting a floating-rate obligation to a fixed-rate one, or vice versa. Derivatives like futures and options can also be used to mitigate exposure to adverse interest rate movements.

Learn more about risk management to strengthen your trading strategy.

Role of monetary policy and inflation control

While not a direct risk mitigation strategy, the role of stable monetary policy and effective inflation control by central banks is crucial in managing systemic interest rate risk. Predictable and transparent monetary policy reduces uncertainty and helps markets price in future interest rate moves more efficiently, thereby reducing sudden shocks.

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Interest rate risk vs. credit risk: key differences

While both are significant financial risks, credit risk is the possibility that a borrower will fail to meet their financial obligations, such as making interest payments or repaying the principal. This risk is inherent in lending and debt instruments. Interest rate risk, on the other hand, is about the sensitivity of an asset’s value to changes in the general interest rates.

Credit risk is predominantly associated with debt instruments where the borrower’s creditworthiness is a factor, such as corporate bonds, bank loans and municipal bonds. Interest rate risk impacts virtually all interest-bearing assets and, indirectly, equities. Even highly creditworthy government bonds carry such risk.

Managing credit risk involves thorough credit analysis, diversification across different borrowers and potentially investing in instruments with higher credit ratings. Managing interest rate risk, as discussed earlier, involves strategies like duration management, diversification and hedging with derivatives.

Understanding both these risks is paramount in both CFD trading and margin trading.

Real-world applications of interest rate risk management

Financial institutions are highly exposed to interest rate risk. They manage it by carefully matching the duration of their assets and liabilities and by employing hedging strategies. This helps them maintain profitability regardless of interest rate changes.

Companies also need to manage interest rate risk related to their debt obligations. A company with significant floating-rate debt will be vulnerable to rising interest rates. They might opt for interest rate swaps to convert their floating-rate debt to fixed-rate, ensuring predictable interest expenses.

Traders constantly monitor interest rate movements to make informed trading decisions. For instance, anticipating a rate hike might lead a trader to reduce exposure to rate-sensitive sectors.

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FAQs

What is the difference between interest rate risk and credit risk?

Interest rate risk is an asset’s value changing due to fluctuations in the general interest rates. Credit risk is the risk that a borrower will default on their debt obligations.

How do rising interest rates impact bond prices?

Rising interest rates cause bond prices to fall because new bonds offer higher yields, making existing bonds with lower yields less attractive.

Can interest rate risk be completely eliminated?

No, interest rate risk cannot be completely eliminated, especially for fixed-income investments. However, it can be significantly mitigated through various strategies like diversification and hedging.

What industries are most affected by interest rate risk?

Industries that are highly dependent on borrowing, such as real estate, utilities and financial services (especially banks), are particularly sensitive to interest rate risk.

What is the risk-free interest rate and how is it calculated?

It is the theoretical rate of return of an investment with zero risk. In practice, it is often approximated by the yield on short-term government securities (like Treasury bills) of a highly creditworthy nation. It isn’t calculated in a traditional sense but observed from the market yields of these instruments.