FP Article 15.8
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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 |
|
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 bond’s 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 bond’s
allure would rise, and so would its price – 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
