A:

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.

RELATED FAQS
  1. 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 >>
  2. 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 >>
  3. What are interest rate swaps on the OTC market?

    Learn about interest rate swaps and how they are traded over the counter, and understand the impact of Dodd-Frank on swaps ... Read Answer >>
  4. Which is better, a fixed or variable rate loan?

    Interest on variable interest rate loans vary as market interest rates change. Interest on fixed interest rate loans will ... Read Answer >>
Related Articles
  1. Trading

    How Are Interest Rate Swaps Valued?

    When trading in financial markets, higher returns are generally associated with higher risk. Hedge your risk with interest rate swaps.
  2. Managing Wealth

    Managing Interest Rate Risk

    You need certain tools to manage the risk that comes with changing rates.
  3. Trading

    An Introduction To Swaps

    Learn how these derivatives work and how companies can benefit from them.
  4. Personal Finance

    Got a Good Mortgage Rate? Lock It Up!

    Rising rates mean rising profits for lenders, providing incentive to increase rates whenever possible.
  5. Investing

    How To Read Interest Rate Swap Quotes

    Puzzled by interest rate swap quotes terminology? Investopedia explains how to read the interest rate swap quotes
  6. Financial Advisor

    Implications of the Federal Reserve's Impending Rate Hike

    The Federal Reserve begins its two-day meeting on Wednesday, September 16, and everyone is watching to see if the central bank will raise the United States target interest rate for the first ...
  7. Trading

    Hedging With Currency Swaps

    The wrong currency movement can crush positive portfolio returns. Find out how to hedge against it.
  8. Investing

    How Interest Rates Affect Mutual Funds

    Find out how changing interest rates impact mutual funds, including bond and money market funds, and how higher rates can discourage investors.
  9. Insights

    When Will Interest Rates Rise?

    Find out if -- and why -- the Federal Reserve will keep raising interest rates and what that might mean for savers, investors and the entire economy.
  10. Investing

    Interest Rates Explained: Nominal, Real, Effective

    Interest rates are divided into subcategories. Smart investors look beyond the nominal or coupon rate of a bond or loan to see if it fits their objectives.
RELATED TERMS
  1. Bond Market Association (BMA) Swap

    A type of swap arrangement in which two parties agree to exchange ...
  2. Delayed Rate Setting Swap

    An exchange of cash flows, one of which is based on a fixed interest ...
  3. Variable Rate Mortgage

    A type of home loan in which the interest rate is not fixed. ...
  4. Liability Swap

    An exchange of debt related interest rates between two parties ...
  5. Lock Period

    A number of days, often 30 or 60, during which the interest rate ...
  6. Floating Interest Rate

    An interest rate that is allowed to move up and down with the ...
Trading Center