Interest rate risk

Interest rate risk is simply the risk to which a portfolio or institution is exposed because future interest rates are uncertain.

Bond prices are obviously interest rate sensitive. If rates rise, then the present value of a bond will fall sharply. This can also be thought of in terms of market rates: if interest rates rise, then the price of a bond will have to fall for the yield to match the new market rates.

The longer the duration of a bond the more sensitive it will be to movements in interest rates.

Shares are also sensitive to interest rates, again it is obvious that if interest rates change (and other things remain equal, which the Fisher effect suggests may not be the case) then DCF valuations will fall. In addition, the profits of highly geared companies will be significantly affected by the level of their interest payments.

Banks can also have significant interest rate risk: for example they may have depositors locked into fixed rates and borrowers on floating rates or vice versa.

Interest rate risk can be hedged using swaps and interest rate based derivatives.

Ways in which interest rate risk can be controlled include: