Interest rate risk is the risk that the value of an investment will decline due to changes in interest rates. It is the risk associated with the fluctuations in the price of an asset caused by changes in the prevailing interest rates in the market.
For instance, if an investor invests in a bond with a fixed interest rate and the prevailing interest rate increases, the value of the bond will decrease. This is because the bond’s fixed interest rate becomes less attractive to investors who can now earn a higher return from newly issued bonds. Similarly, if an investor holds a variable-rate bond, the value of the bond will decline if interest rates fall, as the bond’s interest payments will decrease.
Interest rate risk can affect a wide range of investments, including bonds, mutual funds, exchange-traded funds (ETFs), and even stocks. It is an important consideration for investors because changes in interest rates can have a significant impact on the performance of their portfolios.
To manage interest rate risk, investors can use various strategies such as diversification, duration matching, and hedging. Diversification involves spreading investments across a variety of asset classes, while duration matching involves investing in bonds with maturities that match the investor’s investment horizon. Hedging involves using financial instruments such as options, futures, and swaps to offset the impact of changes in interest rates on an investment portfolio.
How to mitigate against interest rate risk
Interest rate risk can be mitigated by implementing various strategies, including:
- Diversification: Investing in a diversified portfolio of assets can help reduce interest rate risk. Diversification involves spreading investments across different asset classes, such as stocks, bonds, and commodities. By investing in a diversified portfolio, an investor can reduce the impact of interest rate changes on their overall portfolio.
- Duration matching: Duration is a measure of a bond’s sensitivity to interest rate changes. Investors can match the duration of their bond portfolio to their investment horizon. For example, if an investor has a five-year investment horizon, they can invest in bonds with a five-year duration to reduce interest rate risk.
- Bond laddering: Bond laddering involves investing in bonds with different maturities. By doing so, an investor can reduce interest rate risk and take advantage of higher yields on longer-term bonds. As short-term bonds mature, the proceeds can be reinvested in longer-term bonds, which helps to maintain a consistent stream of income.
- Hedging: Hedging involves using financial instruments such as options, futures, and swaps to offset the impact of interest rate changes on an investment portfolio. For example, an investor can use interest rate futures to hedge against rising interest rates.
- Active management: Active management involves regularly reviewing and adjusting a portfolio to reflect changing market conditions. By staying informed and making changes to a portfolio as needed, an investor can reduce interest rate risk.
It’s important to note that no strategy can completely eliminate interest rate risk. However, by implementing these strategies, investors can help mitigate the impact of interest rate changes on their investment portfolios.
About the Author
Dr. Dawkins Brown is the Executive Chairman of Dawgen Global , an integrated multidisciplinary professional service firm .
Dr. Brown earned his Doctor of Philosophy (Ph.D.) in the field of Accounting, Finance and Management
He has over Twenty Six (26) years experience in the field of Audit, Accounting, Taxation, Finance and management . Starting his public accounting career in the audit department of a “big four” firm (Ernst & Young), and gaining experience in local and international audits, Dr. Brown rose quickly through the senior ranks and held the position of Senior consultant prior to establishing Dawgen.
He is a member of Chartered Management Institute (CMI), member of the Institute of Internal Auditors (IIA) , member of the Association of Certified Fraud Examiners (ACFE), member of Information Systems Audit and Control Association ( ISACA ) member of American Planning Association (APA) , member of the American Finance Association (AFA) and member of Association of Certified E-Discovery Specialists (ACEDS).
As Executive Chairman of Dawgen Global , he is responsible for the strategic guidance and strategy execution of several entities within the Dawgen Global Group.
