Interest rate risk

Interest Rate Risk This is the risk that your investment will decline in value as interest rates fluctuate. 

Interest rate risk affects investments such as preferred stocks, utility stocks, bonds and U.S. Treasury securities. To minimize exposure, concentrate on top quality investments and hold until maturity. 

For higher predictability of income, you could invest in bonds. To do so would require you to take on interest rate risk in the event you need to dip into your savings before some bonds reached maturity. There would also be some exposure to loss of purchasing power through inflation although not as severe as with cash equivalent investments. 

Inflation risk occurs when inflation increases, but the return on one s investment does not keep pace with it. An example might be your savings account paying 1 percent interest when inflation is 3 percent. Business-cycle risk refers to the fact that your investments may mirror the fluctuations in the business cycle. For example, stocks typically decline when the economy first enters a recession because the earnings of companies normally decline during recessions. Interest-rate risk may occur when interest rates rise, but you have locked into a lower rate on a long-term bond. For example, if you purchase a 4 percent bond for 10 years, you face the... 

In the previous section, we described a theorem from Dybvig, Ingersoll and Ross stating that extremely long-dated bmid yields cannot decline. This carries implications about the level of interest-rate risk attached to the very long-dated yield. We present a summary of their results here. 

Portfolio managers must also take account of a further relationship between default risk and interest-rate risk. That is, if two corporate bonds have the same duration but one bond has a higher default probability, it essentially has a shorter duration because there is a greater chance that it will experience premature cash flows, in the event of default. 

First, it considers both default risk and interest-rate risk ... 

As one might expect the yields on bonds are correlated, in most cases very closely positively correlated. This enables us to analyse interest-rate risk in a portfolio for example, but also to model the term structure in a systematic way. Much of the traditional approach to bond portfolio management assumed a parallel shift in the yield curve, so that if the 5-year bond yield moved upwards by 10 basis points, then the 30-year bond yield would also move up by 10 basis points. This underpins traditional duration and modified duration analysis, and the concept of immunisation. To analyse bonds in this way, we assume therefore that bond yield volatilities are identical and correlations are perfectly positive. Although both types of analysis are still common, it is clear that bond yields do not move in this fashion, and so we must enhance our approach in order to perform more accurate analysis. 

Risk can thought of as the possibility of unpleasant surprise. Fixed-income securities expose the investor to one or more of the following types of risk (1) interest rate risk (2) credit risk (3) call and prepayment risk (4) exchange rate risk (5) liquidity risk and (6) inflation or purchasing power risk. 

A fundamental property is that an upward change in a bond s price results in a downward move in the yield and vice versa. This result makes sense because the bond s price is the present value of the expected future cash flows. As the required yield decreases, the present value of the bond s cash flows will increase. The price/yield relationship for an option-free bond is depicted in Exhibit 1.9. This inverse relationship embodies the major risk faced by investors in fixed-income securities—interest rate risk. Interest rate risk is the possibility that the value of a bond or bond portfolio will decline due to an adverse movement in interest rates. 

Bonds differ in their exposure to interest rate risk so investors want to know the sensitivity of a bond to change in interest rates. This sensitivity is first approximated by a bond s duration. There are various measures of duration (e.g., Macaulay, modified, effective, etc.) that will be... 

With respect to the first assumption, the risk that an investor faces is that future interest rates will be less than the yield to maturity at the time the bond is purchased. This risk is called reinvestment risk. As for the second assumption, if the bond is not held to maturity, it may have to be sold for less than its purchase price, resulting in a return that is less than the yield to maturity. This risk is called interest rate risk. 

We will discuss two approaches for assessing the interest rate risk exposure of a bond or a portfolio. The first approach is the full valuation approach that involves selecting possible interest rate scenarios for how interest rates and yield spreads may change and revaluing the bond position. The second approach entails the computation of measures that approximate how a bond s price or the portfolio s value will change when interest rates change. The most commonly used measures are duration and convexity. We will discuss duration/convexity measures for bonds and bond portfolios. Finally, we discuss measures of yield curve risk. 

DIHBir 4.5 Illustration of Full Valuation Approach to Assess the Interest Rate Risk of a Bond Portfolio for Four Scenarios Assuming a Parallel Shift in the Yield Curve, 2-Bond Portfolio (hoth bonds option-free)... 

Some managers use another measure of the price volatility of a bond to quantify interest rate risk—the price value of a basis point (PVBP). This mea-... 

Note that our calculation for duration of 17.636 agrees (within rounding error) with Bloomberg s calculation in Exhibit 4.1. Bloomberg s interest rate risk measures are located in a box titled Sensitivity Analysis in the lower left-hand corner of the screen. The duration measure we just calculated is labeled Adj/Mod Duration which stands for adjusted/ modified duration. 

Duration measures the sensitivity of a bond s price to a given change in yield. The traditional formulation is derived under the assumption that the reference yield curve is flat and moves in parallel shifts. Simply put, all bond yields are the same regardless of when the cash flows are delivered across time and changes in yields are perfectly correlated. Several recent attempts have been made to address this inadequacy and develop interest rate risk measures that allow for more realistic changes in the yield curve s shape. ... 

---