Interest Rate vs Interest Rate Risk
Interest Rate and Interest Rate Risk are two Money, Banking & Finance concepts in AP Economics that students often mix up. An interest rate is the cost of borrowing money or the reward for saving it, expressed as a percentage of the principal per year. Interest rate risk is the risk that rising market interest rates reduce the value of a bond or fixed-rate asset, since bond prices move inversely to rates. Here is how they compare side by side.
Interest rates are set in money and loanable-funds markets and steered by the central bank. Lower rates encourage borrowing, investment, and spending; higher rates encourage saving and slow the economy. The real interest rate (nominal minus inflation) reflects the true cost of borrowing.
When market rates rise, existing bonds paying lower fixed coupons become less attractive, so their prices fall, and longer-maturity (higher-duration) bonds fall more. Banks face it because they fund long-term fixed-rate loans with short-term deposits whose cost rises with rates. It is separate from credit risk (default) and liquidity risk (can't sell/fund).
Interest Rate vs Interest Rate Risk: A Level and a Sensitivity
| Interest Rate | Interest Rate Risk | |
|---|---|---|
| What it is | A number you can look up today | How far an asset's value moves when that number changes |
| Units | A percentage per year | A percentage change in price per one point move in rates |
| Who loses when rates rise | New borrowers, who pay more on fresh loans | Existing bondholders, whose holdings lose market value |
| Depends on maturity | Only indirectly, through the yield curve | Directly, and longer maturity means far larger swings |
| Matters if you hold to maturity | Yes, it fixed your coupon on the day you bought | Only on paper, since face value is still repaid in full |
| Where it lands on a bank's books | In interest income and interest expense | In the market value of assets, which can sink a solvent bank |
One point of rates costs a one-year bond under a percent and a perpetual bond about a sixth
Take two bonds that both pay 30 dollars a year. The first repays 500 dollars of principal along with its 30 dollar coupon in one year. The second never repays principal at all and simply pays 30 dollars a year forever. When the market rate is 5 percent, the one-year bond is worth 530 divided by 1.05, or about 504.76 dollars, and the perpetual bond is worth 30 divided by 0.05, or 600 dollars. Now let market rates rise to 6 percent. The one-year bond is worth 530 divided by 1.06, which is exactly 500 dollars, a loss of 4.76 dollars or 0.94 percent. The perpetual bond is worth 30 divided by 0.06, also 500 dollars, but that is a loss of 100 dollars, or 16.7 percent. Same coupon, same issuer, same one point move in rates, and one holder barely notices while the other loses roughly a sixth of the position. That gap is interest rate risk, and it is a property of when the cash arrives rather than a property of the rate. Nothing about creditworthiness changed and both bonds still pay every promised dollar. Practise the pricing at /calculate/yield-to-maturity.
Rates moving is not the risk, being forced to sell is
Interest rate risk becomes a realised loss only if the holder sells before maturity. Hold the one-year bond above to the end and you collect 530 dollars exactly as promised, whatever the market did in between, because the issuer owes a fixed sum and not a market price. A pension fund with outflows it can forecast a decade ahead can usually wait. A bank funded by deposits payable on demand cannot. If depositors withdraw, the bank sells long bonds at the new lower price and the paper loss turns into a real one, which is how an institution whose assets exceed its liabilities on a hold-to-maturity basis still fails. So the distinction flips on the funding side, not on the security. The identical bond carries the identical price sensitivity for both institutions, and only one of them is likely to be forced to crystallise it. That is also the link between this idea and the business model described at /glossary/maturity-transformation, where borrowing short to lend long earns a spread precisely because someone is accepting this risk.
Frequently asked questions
Why do bond prices fall when interest rates rise?
Bond prices fall when interest rates rise because a bond's coupon is fixed in dollars at issue. If new bonds of the same maturity and quality now pay 6 percent while yours pays 4 percent, nobody buys yours at the old price, so the price drops until the fixed coupon plus the discount delivers the same 6 percent return. Nothing about the issuer changed. Only the return available elsewhere did.
Does interest rate risk disappear if you hold a bond to maturity?
Interest rate risk on the price disappears at maturity, because the issuer repays face value regardless of what rates did. Two costs survive. Coupons received along the way get reinvested at whatever rates prevail, so a fall in rates lowers the return you actually compound. And a holder forced to sell early by a funding need never reaches maturity, which is how paper losses on long bonds become real ones for banks.
Which bonds carry the most interest rate risk?
Long-maturity, low-coupon bonds carry the most interest rate risk, because more of their value sits far in the future where discounting bites hardest. A bond paying nothing until it matures in twenty years is the extreme case, since every dollar arrives at the end. A one-year bond sits near the other extreme. Credit quality is a separate axis, so a short government bill and a short low-grade bond have similar rate sensitivity and very different default risk.
Live Loanable Funds graph. Drag the curves, or open the full version.
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