Interest Rate Risks
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We have previously mentioned how the future, as well as its uncertainty, affects the time value of money and brings about the presence of interest. Related to this is risk. In this article we shall take a look at several risks to be considered with regard to interest and interest rates.
What is Interest Rate Risk?
Interest rate risk is the risk that affects an investment value due to changes in future interest rates. Risk is characteristically proportional to reward. For example, investing exclusively in bonds is risky: when interest rates move up, bond prices move down since bonds give back fixed earnings compared to other investments that are affected by the changes in interest rates. Therefore, it is wiser to invest in several different options.
There are two main ways of looking at interest rate risks:
Non-systematic Risk or Book-Value Risk
A non-systematic risk or book-value risk considers how a risk influences the earnings of an investment. This is most often applicable to banking and insurance.
Credit Risk
Credit risk influences how much one can pay based on credit rating or credit score.
Maturity/Term Risk
Often associated with bonds, maturity risk or term risk describes how the earnings of an investment, as in a bond, may change due to its maturity. The longer the term of an investment, the higher the risk. Because of this, interest rates for bonds are normally higher as a reward for taking that risk.
Liquidity Risk
Liquidity risk is the possibility of not being able to liquidate debt. Investments in savings are more liquid than those in bonds and are therefore less risky. Consequently, because bonds are riskier, one can expect higher earnings from them.
Systematic Risk or Market Risk
A systematic risk or market risk is a type of risk that is affected by overall changes in the market. It is particularly applicable in trading and investment management.
Inflation Risk
An inflation risk is the risk that earnings may not be as great as expected due to the dropping purchasing power, or inflation. Again, interest attempts to compensate for such loss.
Exchange Rate Risk
Similar to inflation, exchange rate risk is another type of market risk that is affected by changes in exchange rates.
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