Interest rate risk is the risk that the value of an investment will decline if interest rates rise. This is because bonds, which are one of the most common types of fixed-income investments, are priced based on their yield. When interest rates rise, the yield on new bonds also rises, making existing bonds less attractive to investors. As a result, the price of existing bonds falls.
The amount of interest rate risk an investment has depends on a number of factors, including:
- The length of time to maturity: The longer the time to maturity, the greater the interest rate risk. This is because there is more time for interest rates to change over the life of the bond.
- The coupon rate: Bonds with lower coupon rates are more sensitive to interest rate changes than bonds with higher coupon rates. This is because bonds with lower coupon rates have less income to offset the loss in value if interest rates rise.
- The credit quality: Bonds with lower credit ratings are more sensitive to interest rate changes than bonds with higher credit ratings. This is because investors are more likely to sell bonds with lower credit ratings if interest rates rise, which drives down the price of the bonds.
What are the three types of interest rate risk?
There are three main types of interest rate risk:
- Repricing risk: This is the risk that the value of an investment will decline if interest rates rise. This is the most common type of interest rate risk.
- Yield curve risk: This is the risk that the yield curve will steepen or flatten, which can affect the value of bonds with different maturities.
- Basis risk: This is the risk that the yield on one type of bond will diverge from the yield on another type of bond. This can happen if the credit quality or liquidity of the two bonds is different.
How to mitigate interest rate risk
There are a number of ways to mitigate interest rate risk, including:
- Diversifying your investments: By investing in a variety of assets with different maturities and credit ratings, you can reduce your exposure to interest rate risk.
- Using derivatives: Derivatives, such as interest rate swaps and options, can be used to hedge against interest rate risk.
- Rebalancing your portfolio: By regularly rebalancing your portfolio to ensure that it maintains its desired risk profile, you can reduce your exposure to interest rate risk.
MCQs on Interest Rate Risk
- What is interest rate risk?
- The risk that the value of an investment will decline if interest rates rise.
- The risk that the value of an investment will decline if interest rates fall.
- The risk that the value of an investment will increase if interest rates rise.
- The risk that the value of an investment will increase if interest rates fall.
- Which of the following investments is most sensitive to interest rate risk?
- A 10-year Treasury bond with a 5% coupon rate.
- A 30-year Treasury bond with a 5% coupon rate.
- A 5-year corporate bond with a 5% coupon rate.
- A 5-year Treasury bond with a 0% coupon rate.
- How can you mitigate interest rate risk?
- By diversifying your investments.
- By using derivatives.
- By rebalancing your portfolio.
- All of the above.
Answers to MCQs on Interest Rate Risk
- The answer is (a). Interest rate risk is the risk that the value of an investment will decline if interest rates rise.
- The answer is (b). A 30-year Treasury bond with a 5% coupon rate is the most sensitive to interest rate risk because it has the longest maturity.
- The answer is (d). All of the above are ways to mitigate interest rate risk.