The term risk represents any chance or uncertainty that an outcome will differ from the expected outcome. Usually, any scenario that consists of uncertain possibilities that can result in losses constitutes the risk for that scenario. There are various types of uncertainties that investors can face according to their active market. One type of risk that is prevalent in debt markets is interest rate risk.
What is Interest Rate Risk?
Interest rate risk represents the uncertainty revolving around the interest rates prevalent in the market. For investors who are active in the debt market, an increase or decrease in interest rates can be critical. Therefore, interest rate risk also refers to the probability that unexpected fluctuations in interest rates may cause a decline in the value of an investor’s asset.
Usually, interest rate risks are common in bond markets or other fixed-income investment markets. For investors that receive interest on fixed-rate investments, a decline in interest rates is favourable. That is because these investors benefit from an increased earning while the market rates are down. In contrast, an increase in interest rates can be adverse as it means reduced earnings for these investors.
On the other hand, for any party paying interest on loans, the opposite applies. An increase in market interest rates means the party pays lower interest than the market. Contrastingly, a decrease signifies the party pays higher interest than the market. On top of these losses, investors also make losses on the price of the security they hold. Usually, fluctuations in interest rates also cause the security’s price to alter.
How does Interest Rate Risk affect security prices?
As mentioned, the price of various bonds and debt instruments fluctuates with fluctuations in interest rates. Usually, when the interest rates in the market increase, a fixed-income bond or security will experience a favourable price increase. In these circumstances, most floating-rate interest securities will undergo a price increase.
Furthermore, the maturity period of a debt instrument will also play a substantial role in how the prices will affect it. It is because instruments with a longer maturity will undergo fluctuation longer than an instrument with a short maturity. The longer the maturity period of the bond instrument is, the higher movement it will experience. At maturity, the market price and face value of the bond will equalize.
How do investors manage Interest Rate Risks?
For investors managing interest rate risks is crucial for long-term success. In some circumstances, investors may not have to take any action against fluctuations in interest rates. Usually, these changes are short-term, but some fluctuations may also be long-term. Therefore, investors need to monitor their securities to identify the risks.
Investors have several options when it comes to managing interest rate risks. Usually, investors can choose from forwards, forward rate agreements, futures, swaps, options, embedded options, etc. Using these, investors can hedge the interest rate risks associated with their debt instruments. Most of these techniques involve transferring the risk to another party.
Interest rate risk is the risk involved with instruments that generate interest payments or receipts. Interest rate risks represent any uncertainty around interest rates prevalent in the market. Since any fluctuations in interest rates can affect security prices, investors need to manage their risks actively.