The management of interest rate risk is very crucial in order to minimize the risk of incurring losses in the investment. Interest rate decisions are taken by the Reserve bank of India (RBI) which not only affects the fixed-income securities such as bonds but also the stocks which are trading in the stock market. An active management is absolutely required to manage investments from movement in interest rates.
In this article, we will discuss all the aspects needed in managing interest rate risks (IRR).
Let’s start with the definition.
Interest Rate Risk (IRR) – Definition
Interest rate risk (IRR) is the risk arises due to changes in the market interest rates which affect the value of a company’s assets and liabilities. It can affect any company’s financial condition. The reason we mentioned “Any Company” because it has the potential to affect the companies in the different ways and all companies are sensitive to the fluctuation in interest rates one way or another.
It could result in loss of earnings, diminished profits, and higher costs. If the interest rate increases, the company will be the servicing of debt since it will be a net borrower. High-interest rate means higher interest payments and repayment costs. But, if a company is cash-rich, even then fluctuation in interest rate can affect the company. In decreased interest rates, the company will be exposed to the risk which will impact the size of the yield on its investments. So, either way, the fluctuation in the interest rates can exposed companies to the risks. The most challenging issue companies face is liquidity problems.
Interest Rate Risk & Fixed Income Securities
Interest rate risk has a direct influence on the fixed income securities such as bonds. Besides, interest rates and bond prices are inversely proportional to each other. Means, if there is a rise in interest rates then prices of bonds will fall. So, does the opposite.
Thus, investors who are invested in long-term fixed income securities mostly affected by the fluctuation in interest rates and directly susceptible to interest rate risk (IRR).
To best understand this, let’s suppose an individual bought a 3% fixed-rate-30-year bond for Rs. 10,000. This bond pays Rs. 300/year throughout the maturity. But, if during that time the interest rate rises to 4%, new bonds will pay Rs. 400/year throughout the maturity. In this situation, the individual who is holding onto the 3% fixed-rate-30-year bond would lose the opportunity to earn a higher interest rate. Even in buying the new bond with a 4% interest rate and selling the existing one, he would be required to sell his bond which is no longer attracted to investors since a lower interest rate. To force that sell, he would need to lower his bond price which may affect his returns.
Interest Rate Risk (IRR) & Equity Investors
Changes in interest rates also affect the equity investors who are invested in the stock market. Although, it does not affect equity investors as it affects the bond investors. When the interest rate rises, the corporation’s cost of borrowing money also increases which sometimes result in postponing of borrowing.
When a company borrows less, spend less. And when a company stops spending money, it leads to the slow down in company growth, ultimately lower stock prices.
Investment Products to Manage Interest Rate Risk (IRR)
- Forward Contract: It is the most basic interest rate risk management product which is based on the agreement of an exchange of something at a specific future date. The forward contract has always been used for hedging and speculation.
- Forward Rate Agreements (FRAs): FRA is based on the forward contract where the determinant of profit and loss is an interest rate. It always settled in cash.
- Future Contract: It is another hedging product which can be used to manage the interest rate risk. It is a legal agreement in who two parties agree to buy or sell a particular asset at a predetermined price at a specified time in the future.
- Swaps: Swap is an exchange and the combination of FRAs. Interest rate swap involves one party paying a fixed interest rate and receiving a floating rate however the other party paying a floating rate and receiving a fixed rate.
- Swaptions: A swap option is nothing but a simple option to enter into a swap.
Apart from this, the other investment products are Options contract, embedded options, Caps, Floors, and Collars etc.
In a nutshell, we can say that each of these investment products can provide you with a way to hedge your investment against the interest rate risk. The different products for different circumstances. Hope, this article helped you in a way you expected it to be. If you have any query or would like to add something then don’t forget to mention in the comment section below.
Note: All information & data provided in this article is for the educational purpose as well as to give general information on the finance & economy, not to provide any professional advice or service. Views & opinions are not biased against the company and do not affect any official policy or any other agency, an organization within the content.