Sources of Interest Rate Risk

Here are some notes on the sources of interest rate risk:

  • Monetary policy: Interest rates are largely determined by monetary policy, which is the actions taken by central banks to control the money supply and inflation. When central banks raise interest rates, it makes it more expensive for businesses and consumers to borrow money, which can slow economic growth. This can lead to lower demand for loans, which can in turn lead to lower interest rates on bonds.
  • Inflation: Inflation is another factor that can affect interest rates. When inflation rises, central banks may raise interest rates in an attempt to control it. This can lead to higher interest rates on bonds, which can make them less attractive to investors.
  • Economic growth: Economic growth can also affect interest rates. When the economy is growing rapidly, there is more demand for loans, which can drive up interest rates. This can make bonds less attractive to investors, especially if they are concerned about rising inflation.
  • Market sentiment: Interest rates can also be affected by market sentiment, which is the mood of investors and traders. If investors are feeling pessimistic about the economy, they may sell bonds, which can drive down interest rates. Conversely, if investors are feeling optimistic about the economy, they may buy bonds, which can drive up interest rates.

Here are some MCQs on the sources of interest rate risk:

  1. Which of the following is not a source of interest rate risk?
    • Monetary policy
    • Inflation
    • Economic growth
    • Market sentiment
  2. Which of the following actions by the Federal Reserve is most likely to lead to higher interest rates?
    • Increasing the money supply
    • Decreasing the money supply
    • Raising the federal funds rate
    • Lowering the federal funds rate
  3. If inflation is rising, what is the likely impact on interest rates?
    • Interest rates will rise.
    • Interest rates will fall.
    • Interest rates will remain unchanged.

Answers:

  1. The answer is (d). Market sentiment is not a direct source of interest rate risk. However, it can indirectly affect interest rates by influencing the demand for and supply of bonds.
  2. The answer is (c). Raising the federal funds rate is the most likely action by the Federal Reserve to lead to higher interest rates.
  3. The answer is (a). If inflation is rising, central banks are likely to raise interest rates in an attempt to control it. This can lead to higher interest rates on bonds.