Determinants of interest rate risk

14/05/2020 0 By indiafreenotes

The inverse relationship between the interest rate and bond prices can be explained by opportunity risk. By purchasing bonds, an investor assumes that if the interest rate increases, he or she will give up the opportunity of purchasing the bonds with more attractive returns. Whenever the interest rate increases, the demand for existing bonds with lower returns declines as new investment opportunities arise (e.g., new bonds with higher return rates are issued).

Although the prices of all bonds are affected by interest rate fluctuations, the magnitude of the change varies among bonds. Different bonds show different price sensitivities to interest rate fluctuations. Thus, it is imperative to evaluate a bond’s duration while assessing the interest rate risk.

Generally, bonds with a shorter time to maturity carry a smaller interest rate risk compared to bonds with longer maturities. Long-term bonds imply a higher probability of interest rate changes. Therefore, they carry a higher interest rate risk.

How to Mitigate Interest Rate Risk?

Similar to other types of risks, the interest rate risk can be mitigated. The most common tools for interest rate mitigation include:

  1. Diversification

If a bondholder is afraid of interest rate risk that can negatively affect the value of his portfolio, he can diversify his existing portfolio by adding securities whose value is less prone to the interest rate fluctuations (e.g., equity). If the investor has a “bonds only” portfolio, he can diversify the portfolio by including a mix of short-term and long-term bonds.

  1. Hedging

The interest rate risk can also be mitigated through various hedging strategies. These strategies generally include the purchase of different types of derivatives. The most common examples include interest rate swaps, options, futures, and forward rate agreements (FRAs).

Types of Interest Rate Risks

There are quite a few types of interest rate risks, which must be noted by every investor, be it an individual or a firm. These are explained below in detail.

  • Price risk

The risk of change in the price of an investment bond or certificate is known as its price risk. This leads to unforeseen loss or gains while selling security in the future.

  • Reinvestment risk

The risk of change in their interest rate might lead to the selling of the securities. In turn, this can lead to a loss of opportunity to re-invest in the current interest rate. Known as reinvestment risk, these types of interest rate risk can be further divided into 2 categories.

Name Definition
Duration risk Risk due to the probability of unwillingness to extend an investment beyond its maturity period.
Basis risk Risk of being subjected to a negative downturn in the market.

Factors Impacting Interest Rate Risks of a Firm

There are many factors, which directly impact the interest rate risk associated with a company. These factors are discussed below in detail.

  • Credit risk associated with a company: A company’s debt to equity ratio is one of the primary determinants of credit risk. A rise in interest rates leads to more expense for a company since they have to pay more interest to its investors. As a result, the credit risk of an institution increases.
  • Length of loan terms: Length of loan terms, both as a borrower as well as a lender, are major determinants of the interest rate risks of an institution. Companies and ventures charging a fixed interest on its receivable accounts might have baselines dropping down if they need to refinance themselves. This, in turn, increases the risk involved with the shift in interest rates.
  • Market fluctuation: Market fluctuation and inflation can immensely impact the risk related to interest rates since refinancing, or other such necessities can become more difficult during such times. Such circumstances often lead to a situation where outgoing cash flow crosses the incoming cash flow, making it more difficult for the institution to function.
  • Foreign exchange rates: Any company which has a foreign debt is also affected by a change in foreign exchange rates. The associated interest rate risks increase with fall in the price of the prevalent currency, while the inverse happens in case there is a rise in the price of the currency.

Manage Interest Rate Risks

It is important to learn how to manage interest rate risk since it can potentially make an institution dysfunctional and ultimately bankrupt. The few methods which can be employed to manage the interest rate and in turn associated risks are discussed below.

  • Diversification: Among the different options that can be employed by an institution to manage the interest rate risk associated with them, one of the most effective options is to diversify their financial investments. For investors who invest in both equity and fixed investment options, this is the best method to manage the risks associated with interest rates.
  • Safer investments: The safest option for investors who are trying to reduce the risks associated with interest rates is to invest in bonds and certificates, which have short maturity tenure. Securities with short maturity tenure are less susceptible to the fluctuations in interest rate. This method for interest rate management reduces the chance of being subjected to interest rate fluctuations since they have low maturity tenure.
  • Hedging: Hedging is an option, which can be used successfully to reduce the risks related to interest rates. Generally referring to the purchase of various types of derivatives which are available, there are many ways of hedging. A few of the hedging strategies are illustrated in the table below.
Strategy Definition
1. Forwards The simplest of strategies to combat interest rate risks, this option is the fundamental one on which many other strategies have been formulated. The basic idea behind this management method is to make a specific trade or exchange agreement under the given circumstances though the exchange is to be scheduled for a future date.
2. Forward Rate Agreements As suggested by the name, forward rate agreements are a type of forwarding where the interest rate which is applicable decides the gain or loss. In these types of agreements for interest rate management, one of the involved parties offer fixed interest rates in exchange for floating interest rates which are equal to reference rates.
3. Swaps Much like the name and what it suggests, this method which is often used to manage risks related to interest rates is quite similar to Forwarding rate agreements. Here, the 2 parties involved in an agreement swap the interest rates.
4. Futures Very similar to forwarding contracts, this method of managing interest rate risk involves an intermediary. Typically, the default is lessened in this method. Additionally, the liquidity risk involved in these agreements is much lesser than those of forwards.
  • Selling long-term bonds: A common method which is often used is that of selling the long-term bonds. This effectively clears up the investment funds for re-investment in bonds with higher returns, thus allowing investors to manage the interest rate risk better. It is advisable to re-invest in securities which have shorter maturity tenure since these carry lesser risks related to interest rates.
  • Purchasing floating-rate bonds: Floating rate bonds, as suggested by its name, have a rate of interest, which is directly related to market fluctuations. It is advisable to invest in these securities since being related to the market fluctuations, the return on these investments go up and down too. These should also be bought in a healthy mix of long-term and short-term investments. While this cannot always be used to calculate the exact return, it is helpful in reducing the interest rate risk involved.

It is important for investors to note the above risk management options since risks related to interest rates can greatly affect a company or an investor. Evident from the interest rate risk example mentioned above in this article, managing the risk is necessary to prevent the devaluation of any investment security.