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.

Can individual investors profit from interest rate swaps?
Find out how individual investors can speculate on interest rate movements through interest rate swaps by trading fixed rate ... Read Answer >> 
What is an absolute rate?
An absolute rate is easy to understand once you know the basics of an interest rate swap. An absolute rate is the fixed rate ... Read Answer >> 
How accurate is the forward rate in predicting interest rates?
Find out why forward rates are inconsistent and limited predictors of actual future interest rates, primarily because the ... Read Answer >> 
What is affected by the interest rate risk?
Find out more about interest rate risk, how bond prices are affected by interest rate fluctuations and how interest rate ... Read Answer >> 
Can bond traders trade on interest rate swaps?
Read about interest rate swaps and why these transactions are performed by institutional actors in the bond market, not individual ... Read Answer >>

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