Interest rate risk

Definition

Interest rate risk is the potential for investment losses due to fluctuations in interest rates. It primarily affects bonds and other fixed-income securities, as their values are inversely related to interest rate changes.

5 Must Know Facts For Your Next Test

1. Interest rate risk increases with the maturity of a bond; longer-term bonds are more susceptible.
2. Rising interest rates cause existing bond prices to fall because new bonds pay higher yields.
3. Duration measures a bond's sensitivity to interest rate changes; higher duration means greater risk.
4. Callable bonds have different interest rate risks compared to non-callable bonds because issuers can redeem them if rates drop.
5. Interest rate risk is just one component of overall bond investment risk, which also includes credit/default risk.

Review Questions

• How does an increase in market interest rates affect the price of existing bonds?
• What is the relationship between bond duration and interest rate risk?
• Why do callable bonds have a different level of interest rate risk compared to non-callable bonds?

Related terms

Duration: A measure of a bond's sensitivity to changes in interest rates, expressed in years.

Credit Risk: The possibility that a bond issuer will default on their payments.

Yield Curve: A graph showing the relationship between bond yields and maturities.