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FP Article 15.8 (To sign up for a FREE 16-lesson eCourse on Investment Risk, please click here.)

Investment Risk - Interest Rate Risk

by Rajen Devadason

An interest rate is nothing more - nor less - than the prevailing cost of money.

Rajen Devadason

  Interest rate risk is a particularly interesting form of investment risk.

It is linked directly to the well-known inverse relationship between bond prices and interest rates. One way to understand this is to look at an example:

Let's suppose you buy a bond for $1, and it has a coupon rate of 6%. This coupon rate was determined by the bond issuer when this debt instrument was issued, based upon prevailing interest rates.

 

 

 

 

 

 

 



Now, imagine what happens when the interest rate environment changes. Let's assume here that interest rates start to rise. If interest rates were to soar from the previous 6% level to, say, 9%, this means that investors now have the opportunity to purchase fresh bonds with higher coupon rates.

Obviously this will have the net effect of vastly reducing the attractiveness of the earlier bond in the eyes of yield-savvy investors.

This is an article explaining interest rate risk. I hope you enjoy reading it. But if it isn't what you're looking for, you're welcome to search for something that better meets your needs. Thank you for allowing me to serve you.

Rajen Devadason

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Hard on the heels of that widespread loss of interest in that older, lower coupon bond will come selling pressure.

Naturally, its price will fall. But as it does so, consider carefully what is simultaneously happening: As the bondís price falls, its yield ( = coupon rate/current bond price) rises.

Eventually the bond will settle at a price around 67 cents. Since its coupon rate of 6% on its face value is unchanged, its yield has now risen to match that of the current external environment. The calculation is easy to follow: 6%/0.67 = 9%. 

In simple English that means its effective yield is now 9%, same as existing interest rates. As interest rates rose, the bond price fell.   

Similarly, if interest rates were to fall to 4%, the bondís allure would rise, and so would its price Ė to about $1.50, which would give it an effective yield of 4% based on its 6% coupon rate. 

So, for the purpose of understanding interest rate risk, all you need to remember is that when interest rates rise, bond prices fall, and when rates fall, bond prices rise. Because of the telescoping effect of interest rates compounding more the further out into the future you go, it is logical - and true - that in general interest rate changes tend to affect long-term bonds the most, and short-term ones the least.

Throughout the world, the 3-month US T-bill is deemed the best risk-free asset for two reasons:

1. It is backed by the mighty US Treasury; and

2. It is not affected by interest rate fluctuations because of its extremely short tenure.

As it is usually impossible to predict interest rate movements, this risk is something most investors just have to accept as part and parcel of the investing life. Finally, while interest rate risk is most directly associated with bonds, it also ends up affecting all investments to some extent because, as I've said many times, "An interest rate is nothing more - nor less - than the prevailing cost of money."

If you'd like to continue to learn more about other types of investment risk, here's additional information for you...

15 Types of Investment Risk (OR, to sign up for a FREE 16-lesson eCourse on Investment Risk, please click here.)

1. Borrowing Risk

2. Company Risk

3. Credit Risk

4. Currency Risk

5. Diversification Risk

6. Industry Risk

7. Inflation Risk

8. Interest Rate Risk

9. Liquidity Risk

10. Lost Opportunity Risk

11. Manager's Risk

12. Market Risk

13. Market Timing Risk

14. Political Risk

15. Prepayment Risk

 

 

© Rajen Devadason

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Rajen Devadason, CEO RD WealthCreation Sdn Bhd & RD Book Projects
349, Desa Rasah, Jalan Bayan 7, 70300 Seremban, NS, Malaysia
Tel/Fax: +606 632 8955

 
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