What is Interest Rate Risk?
Interest Rate Risk represents the inherent potential for monetary losses incurred by a lender from fluctuations in the market interest rate.
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How Does Interest Rate Risk Work?
Interest rate risk is an inevitable part of the lending business model for all financial intermediaries offering debt financing and interest-bearing products, particularly for fixed-income securities.
The price of a fixed-rate bond—other than the credit quality of the issuer—is determined by its maturity and coupon rate (%).
- Maturity → The specific date on which the debt principal must be repaid in full per the lending agreement.
- Coupon Rate (%) → The interest rate attached to a debt instrument, which reflects the riskiness and credit profile of the borrower (and determines the value of each interest payment).
Because the market interest rate is rather unpredictable and fluctuates constantly based on the announcement of recent news and external macro events—the underlying financial asset, such as a loan or corporate bond—is at risk of losing a portion of its original price relative to the date of issuance (% of par).
- Higher Market Interest Rates → Lower Fixed-Rate Bond Pricing
- Lower Market Interest Rates → Higher Fixed-Rate Bond Pricing
How to Mitigate Interest Rate Risk
The effect of the market interest rate on the bond pricing environment reflects the concept of interest rate risk, wherein the yield earned by lenders is subject to the current prevailing market conditions.
Therefore, lenders must ensure the proper measures are put into place to mitigate the potential for losses and de-risk their portfolio via hedging strategies.
The most fundamental method to mitigate the interest rate risk is portfolio diversification, with regard to the following factors:
- Portfolio Concentration → Financing Products (e.g. Loans, Bonds, etc.)
- Debt Maturities → Mix of Short-Term vs. Long-Term Issuances
- Borrower Profile → Borrower Type (i.e. Corporate, Consumer), Credit Rating, Context of Financing, Industry or Sector Risks
Financial instruments and derivatives such as interest rate swaps, forward contracts (“forwards”), and future contracts (“futures”) can also be effective methods to hedge against interest rate risk.