Interest rate risk refers to the exposure and potential impact that fluctuations or changes in interest rates can have on the value or returns of an investment or financial instrument. It represents the uncertainty and vulnerability associated with changes in the prevailing interest rates.
When interest rates change, it directly affects the cost of borrowing, lending, or investing money. It can influence the value of fixed-income securities such as bonds, loans, mortgages, and certain derivatives. Interest rate risk can arise due to multiple factors such as changes in central bank policies, economic conditions, inflation expectations, and market demand.
The risk generally arises from the inverse relationship between interest rates and bond prices. If interest rates rise, existing bonds with lower interest rates become less attractive, resulting in a decline in their market value. On the other hand, when interest rates fall, bond prices tend to rise. This fluctuation can lead to potential losses if investors need to sell bonds before maturity.
Interest rate risk commonly affects financial institutions, including banks, as their profitability can be impacted by changes in interest rates. Moreover, it also affects individual borrowers, investors, and companies relying on debt financing.
Managing interest rate risk requires careful analysis, monitoring, and hedging strategies. Investors and financial institutions employ various risk management techniques such as duration matching, interest rate swaps, options, and futures contracts to mitigate the potential adverse effects of interest rate movements and to optimize their investment portfolios.
