Interest Rate Risk
What is Interest Rate Risk?
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.
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 Risk: a worked example
Two bonds each pay 5% when market rates are 5%. Bond A is a perpetual paying $50 a year forever, priced at $50 / 0.05 = $1,000. Bond B matures in one year and pays $1,050, also priced at $1,000. Market rates then rise to 6.25%. Bond A reprices to $50 / 0.0625 = $800, a 20% loss. Bond B reprices to $1,050 / 1.0625 = $988, a loss of about 1.2%. Identical coupon, identical rate move, and the long bond takes roughly seventeen times the hit.
The mistake students make with interest rate risk
The widespread belief is that holding a bond to maturity removes interest rate risk, since face value arrives anyway. The principal does arrive, but the loss took a different form: the money is locked into a below-market coupon for years while new issues pay more, and the drop in market price is the present value of that shortfall. The belief is comfortable because the maturity payment is contractual. It fails badly for a bank, which may have to sell assets or repay depositors long before maturity.
Interest Rate Risk questions
Why do bond prices fall when interest rates rise?
Bond prices fall when interest rates rise because the old bond's coupon is fixed while newly issued bonds pay more. Nobody pays face value for $50 a year when a fresh issue pays $62.50, so the old bond's price drops until its yield matches the market. A perpetual paying $50 is worth $1,000 at a 5% market rate and $800 at 6.25%, the price at which that same $50 yields the new rate.
Do long-term bonds have more interest rate risk?
Long-term bonds carry more interest rate risk than short-term bonds of the same credit quality. A rate change affects every remaining payment, so the more payments still outstanding, the further the price moves; duration puts a single number on that sensitivity. A bond maturing next month barely budges when rates jump, while a 30-year bond can lose a large share of its value on the same news.
How do banks manage interest rate risk?
Banks manage interest rate risk by matching how quickly assets and liabilities reprice. Issuing adjustable-rate loans, holding shorter maturities, funding with longer-term certificates of deposit and using interest rate swaps all narrow the gap between deposit costs that reset fast and loan income that does not. Whatever gap remains is tracked as a duration mismatch, since funding 20-year fixed loans with overnight deposits is exposure by construction.
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