Effects of Interest Rate Risk

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

  • Investment losses: If interest rates rise, the value of bonds will typically fall. This is because bonds with lower yields become less attractive to investors when interest rates rise. As a result, investors may sell their bonds, which can drive down the prices of bonds. This can lead to investment losses for investors who hold bonds.
  • Refinancing costs: For borrowers with variable-rate loans, interest rate risk can lead to higher refinancing costs. This is because when interest rates rise, the borrower’s monthly payments will also rise. This can make it difficult for borrowers to afford their monthly payments, and may lead to default.
  • Bank profitability: Banks are also exposed to interest rate risk. This is because banks typically have a mismatch between the maturities of their assets and liabilities. For example, a bank may have long-term assets, such as mortgages, but short-term liabilities, such as deposits. If interest rates rise, the bank will have to pay more interest on its liabilities, but it will not be able to raise the interest rates on its assets as quickly. This can lead to lower profits for the bank.

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

  1. Which of the following is not an effect of interest rate risk?
    • Investment losses
    • Refinancing costs
    • Bank profitability
    • Higher inflation
  2. If interest rates rise, what is the likely impact on the value of bonds?
    • The value of bonds will rise.
    • The value of bonds will fall.
    • The value of bonds will remain unchanged.
  3. If interest rates rise, what is the likely impact on the cost of borrowing for a borrower with a variable-rate loan?
    • The cost of borrowing will rise.
    • The cost of borrowing will fall.
    • The cost of borrowing will remain unchanged.

Answers:

  1. The answer is (d). Higher inflation is not an effect of interest rate risk. It is a separate economic factor that can affect interest rates.
  2. The answer is (b). If interest rates rise, the value of bonds will fall. This is because bonds with lower yields become less attractive to investors when interest rates rise.
  3. The answer is (a). If interest rates rise, the cost of borrowing for a borrower with a variable-rate loan will also rise. This is because the borrower’s monthly payments will be adjusted to reflect the higher interest rates.