Overview ON Interest rate risk
Interest rate risk is the likelihood of investment losses as a result of changing interest rates. If interest rates rise, for example, the value of bonds or other fixed income investments will decline. The change in the bond price is known due to the change in interest rates as its duration.
Interest rate risk can be reduced by holding bonds with different periods, and investors can also mitigate interest rate risk by hedging fixed income investments through interest rate swaps, options or other interest rate derivatives.
Interest rate risk is that a change in overall interest rates may reduce the value of the bond or other fixed-rate investment, as interest rates rise, bond prices fall, and vice versa. This means that the market price of existing bonds is falling to offset the more attractive prices for new bond issues.
Interest rate risk is measured by the duration of fixed income security, with a greater sensitivity to long-term bonds to price changes. Interest rate risk can be reduced by diversifying bond maturities or hedging using interest rate derivatives.
As for the definition of interest rate, the rate paid by the Central Bank on commercial bank deposits whether it is an overnight investment or for a month or more, and raising interest means curbing borrowing and thus reducing liquidity in the market, leading to lower inflation.
Interest rate risk
Interest rate changes can affect many investments, but directly affect the value of bonds and other fixed-income securities. Therefore, bondholders watch interest rates carefully and make decisions based on how interest rates change is perceived over time.
For fixed-income securities, as interest rates rise, stock prices fall (and vice versa). This is because when interest rates rise, the opportunity to hold these bonds increases — the cost of losing a better investment is greater. Thus, the rates earned on bonds have less attractiveness as prices rise, so if a bond that pays a fixed rate of 5% is traded at a face value of $1000 when the prevailing interest rates are also at 5%, earning it becomes much less attractive. The same 5% when rates elsewhere start to rise to say 6% or 7%. In order to compensate for this economic disadvantage in the market, the value of these bonds must be reduced – because those who want to have a 5% interest rate while can get 7% of some different bonds.
For fixed-rate bonds, when interest rates rise above that fixed level, investors turn to investments that reflect higher interest rates. Securities issued before the interest rate change can compete with new issues only by lowering their prices.
It should be noted that there is a difference between the interest rate and the discount rate, where the interest rate is defined as the percentage of the capital value, paid by the borrower to the creditor for the use of his savings for a period of time.
How to mitigate interest rate risks
If a bondholder is afraid of interest rate risk that could adversely affect the value of his portfolio, he or she can diversify his current portfolio by adding securities that are less vulnerable to interest rate fluctuations (e.g., equity). If an investor has a "bond-only" portfolio, he or she can diversify the portfolio by including a combination of short-term and long-term bonds.
Interest rate risk can also be mitigated through various hedging strategies. These strategies generally involve the purchase of different types of derivatives. The most common examples include interest rate swaps, options, futures and futures agreements (FRAs).
Types of interest rate risk
There are few types of interest rate risk that every investor, whether an individual or a company, should notice:
Price volatility risks
The risks of a change in the price of a bond or investment certificate are known as price risk. This results in unexpected loss or gains during future securities sales.
The risk of a change in interest rate may lead to the sale of securities. In contrast, this can result in a loss of opportunity to reinvest in the current interest rate. known as reinvestment risk.
Credit risk is the risk of loss that may occur from a party's failure to comply with the terms and conditions of any financial contract and, essentially, non-payment of the required payments on loans due to an agent.
As a financial intermediary, the Bank's project finance division is exposed to risks for lending, business and the environment in which it operates. The main objective of project financing in risk management is to ensure that it understands, measures and monitors the various risks that arise and that the organization is strictly committed to the policies and procedures designed to address these risks. Companies have an structured credit approval process that includes a well-established comprehensive credit assessment procedure.
Bank interest rate risk
Banks engage in excessive risk. There are a large number of ways in which banks can take a lot of risks. They may offer speculative loans, for example. The savings and loan industry has been involved in speculative lending but has also been exposed to risks through the provision of long-term mortgages financed by short-term deposits. This creates so-called interest rate risk.
As one of his duties, the Federal Reserve regulates the safety of some banking organizations. This means that the Fed monitors the risks of these banking organizations, examines them and takes steps to prevent them from risking excessive levels. As a result, the Fed has a lot of interest in topics such as interest rate risk. Not only does the Minneapolis Fed devote significant resources to regulating banks, but it is paying serious attention — in the Fed and other publications — to the impact of regulatory policy on bank ing risk.
The internal rate of return has the potential to have a negative impact on the bank's profits and net wealth. Banks will earn less money without incurring these risks. By gaining the difference between long-term and short-term interest rates, for example, banks are paid to bear the internal rate of return and meet customer demands for deposits and loans. The challenge for banks is to measure and manage the internal rate of return so that the compensation they receive is appropriate for the risks they incur.
Focusing on bank risk management in this case is particularly important because, as noted in several Minneapolis Fed publications, taxpayers who support the safety net of banks take some risk in banks. These concerns are always increased in periods such as the current period where the internal rate of return rises. In the Kingdom, Saipur is defined as the interbank interest rate when borrowing from another bank.