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What is Interest Rate Risk?
The interest rates of bonds keep changing in the market and this exposes investors to a risk known as interest rate risks. The interest rate risk is the risk arising due to the fluctuation of interest rates. It is pretty common in the markets and investors to keep a close eye on these types of risks to calculate the value of their portfolio including bonds and equity shares.
Bonds with longer maturity have a higher risk than a bond of shorter maturity. For example, in a case of a bond that gives 10% back annually for a par value of INR 100 annually, it would be a wise decision to withdraw the money after six months (INR 105) and reinvest it in some other vehicle.
Opportunity Risk
The example given above shows the relationship between interest rise and the loss of a bond's value. While purchasing a bond, the investor assumes that when interest rates rise, he or she will give the opportunity of earning more up by not selling the bonds he or she currently holds.
Although all bonds are affected by interest rate fluctuations, the magnitudes differ widely. The interest rates are subject to sensitivities arising due to fluctuations. So, it is helpful to derive the bond's duration while assessing the risks.
How to Lower Interest Risks?
Hedging − The interest rate risks can be mitigated to a large extent by hedging. The hedging strategies generally include the purchase of different types of derivatives. The most common examples include options, futures, interest rate swaps, and forward rate agreements (FRAs).
Diversification − By diversifying the portfolio, investors can diminish the risk factors. As all bonds don't go down together, diversification is meaningful and helpful in mitigating the interest risks.
Points to Note
Interest rate risks are risks associated with the interest of a bond. Usually, a loss of interest is considered in interest rate risks rather than gains from them.
Bonds with longer maturity periods pay less and are riskier. The decision to buy redeemable bonds and sell them at an opportune moment is the key to get the best returns on investment.
It is imperative that investors pre-judge the interest rate fluctuations to mitigate their interest rate risks. Buying too risky or too stable options may both be harmful in a financial sense.
By hedging or diversifying their portfolio, investors can protect the value of their investments from going down.
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