Interest Rate Risk

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Interest Rate Risk
Interest rates are the amount charged for borrowing money. It shows the borrower the high rewards for saving or the borrowing cost. The rates are primarily in the percentage of the capital. Accepting and managing financial risk is part of the roles handled by financial intermediaries to meet the communities’ and customers’ demands. Understanding risk help in the purchase of securities, taking deposits with different interest rates or maturities and executing financial strategies. These activities expose the institution’s capital and earnings to increase and decline in interest rates, thus increasing interest rate risk (Hoffmann et al., 2019). The threat affects investment return in bonds and stocks. Interest rate change reflects in bond prices.
Interest rates relate to assets such as bonds. They correspond to risk in that the assets rely on rates to decline in value due to interest rate fluctuations. Individuals expect to lose value when investing in bonds or bond funds. Bond prices fall when interest rates rise, and bond prices rise when interest rates fall, this is the cardinal bond rule. The risk is that interest rate change may decrease the bond market value. Increasing interest rates result in more attractive bonds due to rising coupon rates. High-interest rates in a short period can hugely affect overall fund performance.
The longer the period of bond investment, the higher the chance that several factors may negatively affect a person’s investment or a greater attractive investment chance will come up, which is known as opportunity risk. The risk associated with interest rates brings about other risks, such as reinvestment rate risk; an investor can not reinvest bond money at the same rate. Investors can diversify holdings to mitigate this risk. Portfolio duration knowledge is essential to measure the risk. It helps show the investment time frame and sensitivity to potential changes.
 

References
Hoffmann, P., Langfield, S., Pierobon, F., & Vuillemey, G. (2019). Who bears interest rate risk?. The Review of Financial Studies, 32(8), 2921-2954.

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