To calculate interest-rate risk, use the following formula: (Original price – new price)/(Original price – new price)/(Original price – new price)/(O
What is the formula for calculating interest rate risk?
- The danger that a change in general interest rates will affect the value of a bond or other fixed-rate investment is known as interest rate risk:
- Bond prices decline as interest rates rise, and vice versa. As a result, the market price of old bonds falls to compensate for the lower rates offered by new bond offerings.
- The duration of a fixed income security is used to calculate interest rate risk, with longer-term bonds having more price sensitivity to rate movements.
- Interest rate risk can be mitigated by diversifying bond maturities or by using interest rate derivatives to hedge interest rate risk.
What is a bond’s interest rate risk?
Remember the cardinal law of bonds: bond prices rise when interest rates decrease, and bond prices fall when interest rates rise. Interest rate risk refers to the possibility that changes in interest rates (in the United States or elsewhere in the world) will lower (or raise) the market value of a bond you own. The longer you keep a bond, the higher the interest rate risk, also known as market risk.
Assume you purchased a $1,000 10-year bond today at a coupon rate of 4%, and interest rates rise to 6%.
If you want to sell your 4% bond before it matures, you’ll have to compete with newer bonds with greater coupon rates. These higher coupon rate bonds reduce demand for older, lower-interest-paying bonds. The price of older bonds in the secondary market is depressed as a result of the weaker demand, which means you’ll get a lower price for your bond if you need to sell it. It’s possible that you’ll have to sell your bond for less than what you bought for it. Because of this, interest rate risk is also known as market risk.
Rising interest rates make new bonds more appealing as well (because they earn a higher coupon rate). This creates what’s known as opportunity risk: the possibility that a better chance will present itself that you will be unable to take advantage of. The longer the period of your bond, the more likely it is that a better investment opportunity may arise, or that a variety of other events will occur that will negatively effect your investment. This is also known as holding-period risk, which is the risk that not only will you miss out on a better chance, but that something will happen during the time you hold a bond that will negatively impact your investment.
Individual bondholders bear the same risks as bond fund managers. When interest rates rise, especially in a short period of time, the value of the fund’s existing bonds decreases, putting a drag on total fund performance.
Is there a market risk associated with interest rate risk?
Interest rate risk, equities risk, commodity risk, and currency risk are the most prevalent types of market risk. Interest rate risk refers to the potential for interest rate variations to cause volatility, and it is especially relevant to fixed-income investments. Equity risk refers to the risk associated with changing stock prices, whereas commodity risk refers to the risk associated with changing commodity prices such as crude oil and corn. Currency risk, also known as exchange-rate risk, develops when the price of one currency fluctuates in respect to another. This could have an impact on investors with assets in other countries.
What are the different kinds of interest rate risk?
As a result, the sections that follow detail the most common types of interest rate risk to which banks are exposed. Repricing risk, yield curve risk, basis risk, and optionality risk are among them, and each is described in greater depth below.
What is the relationship between interest rate and inflation risk?
Interest rate risk refers to the danger of losing value in assets because the interest rates you receive have the potential to lag behind market interest rates or inflation rates. Because of inflation, the amount of items you can buy with a single unit of currency decreases.
How is bond risk assessed?
The risk exposure of fixed-income assets is managed using two tools: duration and convexity. The sensitivity of a bond to interest rate fluctuations is measured by its duration. The relationship between a bond’s price and yield as interest rates vary is referred to as convexity.
In the banking book, what is interest rate risk?
The current or prospective risk to the bank’s capital and earnings coming from adverse interest rate movements that influence the bank’s banking book positions is referred to as interest rate risk in the banking book (IRRBB). The present value and timing of future cash flows fluctuate when interest rates change. As a result, the underlying value of a bank’s assets, liabilities, and off-balance sheet items, as well as the bank’s economic worth, fluctuates. Interest rate changes also have an impact on a bank’s earnings through changing interest rate-sensitive income and expenses, as well as net interest income (NII). If not managed properly, excessive IRRBB can constitute a major risk to a bank’s current capital base and/or future earnings. SRP98 contains a more extensive description of IRRBB and its management strategies.
What is the method for calculating interest rate sensitivity?
The Macaulay duration, modified duration, effective duration, and key rate duration are four commonly used duration measurements to estimate a fixed-income security’s interest-rate sensitivity. Certain criteria, such as the time to maturity, remaining cash flows, necessary yield, cash flow payment, par value, and bond price, must be known in order to compute the Macaulay duration.