Interest rate risk is a crucial component for those who invest in rate-sensitive financial instruments, such as bonds. It represents the possibility that a change in interest rates will negatively affect the value of these assets, with direct implications for the return on investment. When interest rates rise, the price of fixed-rate bonds tends to fall, thus penalizing investors. This phenomenon is known as the inverse correlation between price and yield to maturity.
Contents
Effects of interest rate risk: reinvestment and value
When it comes to bonds, two main effects emerge from changes in interest rates: the reinvestment effect and the value effect. The first occurs when an investor has the opportunity to reinvest cash flows at a higher rate, benefiting from an increase in rates. The second, on the other hand, manifests itself in a reduction in the value of fixed-income securities as their future cash flows are discounted at a higher rate of return, reducing their overall value.
Duration and rate sensitivity
One way to measure a bond’s sensitivity to changes in interest rates is through duration, a metric that expresses the degree of volatility of a security’s price relative to changes in rates. Securities with a longer duration are more exposed to fluctuations in rates, while securities with a shorter duration tend to be less volatile and therefore safer in variable rate environments. Duration depends on various factors, such as the maturity of the security and the level of its coupon payments.
Hedging instruments against interest rate risk.
To hedge against interest rate fluctuations, investors can use derivative instruments such as interest rate futures, options, and swaps. These instruments allow investors to reduce the risk of depreciation of fixed-income securities. For example, an investor can sell an interest rate future to offset a possible loss on the value of a fixed-rate bond, thus protecting himself or herself from rising rates.
This article was created and reviewed by the author with the support of artificial intelligence tools. For more information, please refer to our T&Cs.
This article or page was originally written in Italian and translated English via deepl.com. If you notice a major error in the translation you can write to adessoweb.it@gmail.com to report it. Your contribution will be greatly appreciated
Giuseppe Fontana
I am a graduate in Sport and Sports Management and passionate about programming, finance and personal productivity, areas that I consider essential for anyone who wants to grow and improve. In my work I am involved in web marketing and e-commerce management, where I put to the test every day the skills I have developed over the years.
