Interest Rate Risk
Introduction
In finance, interest rate risk is the risk that the price of a security that earns a fixed interest, such as a "Bond (finance)") bond, an obligation or a loan, is affected by a variation in market interest rates. In general, an increase in market interest rates negatively influences the price of a fixed coupon bond and conversely, a decrease in interest rates will positively affect the price of fixed coupon bonds.[1].
Interest rate risk can be measured by the duration of the security; the longer the life of the security, the more this risk increases. Duration is the oldest of many techniques used for interest rate risk management.
Influence of the interest rate on the price of securities
As mentioned before, variations in interest rates usually affect the price of securities. The mechanism to explain this influence can be seen with an example:
A fixed income security issued at 10% interest will have a certain valuation. If the market interest rate falls to 2%, for example, the reference security will appreciate because it offers an interest rate much higher than that offered by the market (10% of the security compared to 2% of the market), therefore its price will rise. On the contrary, when market rates rise, let's say from the 10% they were at to 15%, the price will drop, since the reference security will no longer be attractive as it offers a lower interest rate than the market remunerates, and if someone wants to sell it they will have to lower its price to achieve this.
Another way to observe the influence of market interest rates on the price of a security is through the financial mechanism by which the price of a bond or in general any security is calculated. The price of a fixed-income bond is calculated by taking to the current moment all the payments that are expected to be obtained for it, that is, the coupons to be collected and the amortization. To do this, a financial technique consisting of updating the flows obtained is used. To update these cash flows, an interest or discount rate must be used. Mathematically, it can be observed that the higher the interest rate used in the update, the lower the value we obtain from the bond, because the discount made to attract it to the current moment is greater. Which brings us to the same type of relationship explained above, a rise in interest rates leads to a fall in the price of bonds in the market.
References
- [1] ↑ Mascareñas, Juan (2006). «Características de los Activos Financieros de Renta Fija». Monografías de Juan Mascareñas sobre Finanzas Corporativas. ISSN 1988-1878. Consultado el 12 de noviembre de 2012.: http://www.ucm.es/info/jmas/mon/08.pdf