Let’s review one such risk:
Interest Rate Risk
Interest rate risk is the risk that an investment’s value will change as a result of a change in interest rates. This risk affects the value of bonds more directly than the value of stocks. When interest rates rise, bond prices fall; conversely, when interest rates fall, bond prices rise. This is known as the inverse relationship between price and yield.
Higher interest rates make it more expensive for both consumers and businesses to borrow. While this reduces the threat of inflation, it slows economic growth, curtails corporate profits, and potentially depresses stock prices.
Questions on Interest Rate Risk
To be well-prepared, candidates should be able to answer the following questions:
Q: Changing interest rates and the subsequent effect on bond prices describes what type of risk?
A: If investors own debt securities (e.g., Treasury notes) and believe interest rates will rise, they will be concerned about interest rate risk.
Q: What is one sub-category of interest rate risk?
A: Repricing risk is a sub-category of interest rate risk. This refers to the risk that a change in prevailing interest rates will cause the bond’s market value to change, or be repriced.
Q: How can repricing risk be reduced?
A: One way to reduce repricing risk is to issue bonds with a floating interest rate based on a benchmark (e.g., Treasury rates or the London Interbank Offered Rate—LIBOR) rather than a fixed interest rate. Because these bonds will always pay a “market” rate, their value will fluctuate less than similar fixed-rate bonds.
Q: What is interest rate arbitrage?
A: Interest rate arbitrage is a strategy used to capitalize on differences in interest rates. As an example, an investor holding long-term assets (e.g., 20-year bonds with high coupons) that are funded with short-term loans (at low interest rates) might be engaging in an interest rate arbitrage strategy.