INTEREST RATE RISK

INTEREST RATE RISK

Interest rate risk is the risk suffered by bond owners due to fluctuating interest rates. Market is never stable and interest rates are stochastic in nature,i.e,they changes over time.Therefore, bond owners are at a huge risk due to these changes.The degree of interest rate risk depends upon how much its price is sensitive to the interest rate changes.The sensitivity depends upon two things:

  1. the bond’s time to maturity
  2. coupon rate of the bond

If the maturity period of the bond is long it will be more sensitive to the interest  rate risk and vice versa.If high interest rate risks are involved then this risk would be compensated with higher coupon rate as compared to bonds with low interest rate risk.As a result bonds with higher coupon rate results in lower interest rate risk and vice versa.

Interest rates have a huge impact upon the prices of the bond. When interest rate goes up ,prices of the bond fall,and when the interest rate goes down prices of the bond rises.This is because when interest rate goes up people would be more inclined towards saving and depositing money in the banks,thus the demand of bonds fall which causes their price to fall.

WAYS OF CALCULATING INTEREST RATE RISK:

  • Marking to market,calculating the net market value of the assets and liabilities, sometimes called the “market value of portfolio equity”
  • Calculating the value at risk of the portfolio
  • Analyzing duration,convexity and key rate duration.
  • Stress testing this market value by shifting the yield curve in a specific way.

The seesaw effect between interest rates and bond prices applies to all bonds, even to those that are insured or guaranteed by the government. When the government guarantees a bond, it guarantees that it will make interest payments on the bond on time and that it will pay the principal in full when the bond matures. There is a misconception that, if a bond is insured or is a government obligation, the bond will not lose value. In fact, the government does not guarantee the market price or value of the bond if you sell the bond before it matures. This is because the market price or value of the bond can change over several factors including interest rate risk.

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