Interest Rate Risks

 Interest Rate Risks

Interest rate risks occur when the interest rate on a bond is unstable or fluctuates.

The amount of risk depends on how sensitve the market is to changes in interest

rates. The duration of the bond, the maturity, and the coupon rate all play a role in

determining how prone a bond is to interest rate risk. Investing in bonds can have

some of the greatest risks of all. However, there are several ways to mitigate this

risk.

Interest rate risk

Depending on how you define interest rate risk, there are many ways to hedge your

investments. Firstly, diversify your portfolio. The longer-term your bonds are, the

more sensitive they are to rate changes. This is because an increase in rates would

cause a significant reduction in the price of your bonds. You can reduce your interest

rate risk by diversifying your bonds by maturity date, as well as hedging the risk

with interest rate derivatives.

Duration

One measure of risk is the duration of interest rates. While it can be a useful

analytical tool, duration cannot fully evaluate the credit risk of a bond or determine

its credit quality. However, duration is important for lower-rated securities, which

often react more negatively to investor concerns about the company's stability. This

article discusses the different measures of interest rate risk. To understand how

these measures differ from one another, we will examine two examples of long-term

and short-term bonds.

Basis risk

The basis risk of interest rate risks arises from the changes in spreads and

relationships between interest rates. For example, if a bank finances loans at Libor,

it faces the risk of narrowing the spread. A portfolio containing junk bonds is also

exposed to basis risk as the yield spread could change. Also known as spread risk,

basis risk can be managed by following proper market trends. However, it is

important to consider the hedging instruments available to avoid locking in losses.

Prepayment risk

Interest rate risks include two primary categories: prepayment risk and change of

interest rate. Changes in interest rates are difficult to predict, but they do increase

the likelihood of prepayment. For example, the Federal Reserve's quantitative

easing in 2007 almost halved the 30-year fixed mortgage rate. This resulted in

many homeowners prepaying their loan obligations early. As a result, interest rates

will continue to rise until at least the end of 2019.

Diversification

While investing in stocks, bonds, and mutual funds is common, many investors are

unaware of the benefits of diversification. Diversification reduces risk by avoiding

the extremes. By reducing risk, diversification also rewards investors by averaging

returns across different assets. Diversification is a good idea for older investors,

retirees, and anyone approaching retirement. Diversification is also thought to

improve risk-adjusted returns, which measure the efficiency of capital deployment.

Hedging

Hedging interest rate risks can be achieved in a variety of ways, each one tailored to

different situations and requiring specific knowledge. In addition, hedging cannot be

considered as a free lunch - you must make an investment and pay an opportunity

cost as well. To reduce the opportunity cost and maximize the return, different

products offer different advantages. This article will provide an overview of some of

the common methods of hedging interest rate risks.

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