What Is Interest Rate Risk?

Description: Interest rate risk is the danger that arises for many bondholders from unpredictable interest rate fluctuations. How much interest rate risk a particular bond has largely depends upon how sensitive its underlying bond market is. The volatility of the interest rate is measured by the volatility of bond prices. The greater the volatility, the more sensitive is the bond to any change in the expected interest rate. How volatile the bond market also depends upon the tolerance of a bondholder to fluctuations in bond prices. A bondholder may be more or less flexible depending on their tolerance for risk. More info here.

Interest rate hedge tax treatment affects the interest rate risk? If a bond price moves up and down sharply, it can cause large bond price changes which can be very risky for the bondholders. Bond prices move either up or down because of changes in economic fundamentals such as growth in the economy & consumer price index (CPI), employment growth, inflation, political stability, etc. The interest rate is basically an assessment of how inflation will affect future bond prices.

On the flip side, if a bond price falls drastically, then this can be very safe for the bondholder. The bond price normally moves down because of a fall in market expectations and confidence. So the low-interest-rate environment is also referred to as a support zone for most bonds. To understand this better, you need to learn about the technical characteristics of volatility and its effect on the interest rate risk.

Bonds that are considered to be “safe” typically offer a fixed interest rate with duration over the years at which it’s a good idea to buy. So these types of bonds are called “base” bonds. While these bonds provide no additional risk than a given level of inflation, they don’t have any risks associated with them based on economic factors. The “overbought” bonds are normally considered to be “oversold” by their issuers and the selling price is more than the balance of the loan.

So, what determines “overbought” or “undersold” bonds? The primary factors that contribute to risk involve interest rate risk and maturity risk. These are basically just the opposite ends of the spectrum. The amount of risk that exists is dependent on the condition of the market makers, risk-premium, and credit spread.

When determining the interest rate you should look at what is called the yield to cover, or the rate at which the bond would be bought if the market was bullish. This rate is typically higher than the current market price for the same security because the bonds that are being purchased now are offering a higher interest rate. The opposite is true when determining the term of a bond. Bond prices usually increase over time as the term increases. This means that the rate you pay for a bond will decrease as time passes by.


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