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What is 'Interest Rate Risk'

The interest rate risk is the risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve, or in any other interest rate relationship. Such changes usually affect securities inversely and can be reduced by diversifying (investing in fixed-income securities with different durations) or hedging (such as through an interest rate swap).

BREAKING DOWN 'Interest Rate Risk'

Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders. As interest rates rise, bond prices fall, and vice versa. The rationale is that as interest rates increase, the opportunity cost of holding a bond decreases, since investors are able to realize greater yields by switching to other investments that reflect the higher interest rate. For example, a 5% bond is worth more if interest rates decrease, since the bondholder receives a fixed rate of return relative to the market, which is offering a lower rate of return as a result of the decrease in rates.

Market Interest Rates

Interest rate risk is most relevant to fixed-income securities whereby a potential increase in market interest rates is a risk to the value of fixed-income securities. When market interest rates increase, prices on previously issued fixed-income securities as traded in the market decline, since potential investors are now more inclined to buy new securities that offer higher rates. Only by having lower selling prices can past securities with lower rates become competitive with securities issued after market interest rates have turned higher.

For example, if an investor buys a a five-year bond that costs $500 with a 3 percent coupon, interest rates may rise to 4%. In that case, the investor may have difficulty selling the bond when others enter the market with more attractive rates. Older bonds look less attractive as newly issued bonds carry higher coupon rates as well. Further, lower demand may cause lower prices on the secondary market, and the investor is likely to get less for the bond on the market than he paid for it. 

Price Sensitivity

The value of existing fixed-income securities with different maturities declines by various degrees when market interest rates rise. This is referred to as price sensitivity, meaning that prices on securities of certain maturity lengths are more sensitive to increases in market interest rates, resulting in sharper declines in their security values.

For example, suppose there are two fixed-income securities, one maturing in one year and the other in 10 years. When market interest rates rise, holders of the one-year security could quickly reinvest in a higher-rate security after having a lower return for only one year. Holders of the 10-year security would be stuck with a lower rate for 9 more years, justifying a comparably lower security value than shorter-term securities to attract willing buyers. The longer a security's maturity, the more its price declines to a given increase in interest rates.

Maturity Risk Premium

The greater price sensibility of longer-term securities leads to higher interest rate risk for those securities. To compensate investors for taking on more risk, the expected rates of return on longer-term securities are normally higher than on shorter-term securities. This extra rate of return is called maturity risk premium, which is higher with longer years to maturity. Along with other risk premiums, such as default risk premiums and liquidity risk premiums, maturity risk premiums help determine rates offered on securities of different maturities beyond varied credit and liquidity conditions.

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