by Economic factors involve all the determinants of the economy and its state. These are factors that can conclude the direction in which the economy might move. Businesses analyze this factor based on the environment. It helps to set up strategies in line with changes.
Factors are affecting business:
- The inflation rates
- The interest rate
- Disposable income of buyers
- Credit accessibility
- Unemployment rates
- The monetary or fiscal policies
- The foreign exchange rates
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.
Interest Rate High ↑ = Asset’s Vale ↓
Interest rate risk analysis is almost always based on simulating movements in one or more yield curves using the Heath-Jarrow-Morton framework to ensure that the yield curve movements are both consistent with current market yield curves and such that no riskless arbitrage is possible. The Heath-Jarrow-Morton framework was developed in the early 1991 by David Heath of Cornell University, Andrew Morton of Lehman Brothers, and Robert A. Jarrow of Kamakura Corporation and Cornell University.
The risk of value depreciation of bonds and other fixed-income investments is known as interest rate risk. Primarily due to depreciation in their interest rates, this happens because of market fluctuations. Such risk affects many types of investments, though it primarily affects fixed-income investments like bonds and certificates.
Typically, with a rise in the interest rate of a bond or certificate, there is a fall in the price of all related securities. Additionally, opportunity cost increases too, along with a rise in their interest rate. Defined as the cost of missing out on better investment options, this opportunity cost is directly proportional to the interest rate risk.
There are a number of standard calculations for measuring the impact of changing interest rates on a portfolio consisting of various assets and liabilities. The most common techniques include:
- Marking to market, calculating the net market value of the assets and liabilities, sometimes called the “market value of portfolio equity”
- Stress testing this market value by shifting the yield curve in a specific way.
- Calculating the value at risk of the portfolio
- Calculating the multiperiod cash flow or financial accrual income and expense for N periods forward in a deterministic set of future yield curves
- Doing step 4 with random yield curve movements and measuring the probability distribution of cash flows and financial accrual income over time.
- Measuring the mismatch of the interest sensitivity gap of assets and liabilities, by classifying each asset and liability by the timing of interest rate reset or maturity, whichever comes first.
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.
Mitigate Interest rate Risk
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.
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.
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.
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.
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.
