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Investors can reduce interest rate risk with forward contracts, interest rate swaps and futures. Investors may desire reduced interest rate risk to reduce uncertainty of changing rates affecting the value of their investments. This risk is greater for investors in bonds, real estate investment trusts (REITs) and other stocks in which dividends make up a healthy portion of cash flows.

Primarily, investors are concerned about interest rate risk when they are worried about inflationary pressures, excessive government spending or an unstable currency. All of these factors have the ability to lead to higher inflation, which results in higher interest rates. Higher interest rates are particularly deleterious for fixed income, as the cash flows erode in value.

Forward contracts are agreements between two parties with one party paying the other to lock in an interest rate for an extended period of time. This is a prudent move when interest rates are favorable. Of course, an adverse effect is the company cannot take advantage of further declines in interest rates. An example of this is homeowners taking advantage of low interest rates by refinancing their mortgages. Others may switch from adjustable rate mortgages to fixed rate mortgages as well.

Interest rate swaps are agreements between two parties in which they agree to pay each other the difference between fixed interest rates and floating interest rates. Basically, one party takes on the interest rate risk and is compensated for doing so.

Futures are similar to forward contracts and interest rate swaps, except there is an intermediary. This makes the arrangement more expensive but there is less chance of one party failing to meet obligations. This is the most liquid option for investors.

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