What is an Interest Rate Risk?

An interest rate risk is the degree of volatility or risk that is associated with securing a given interest rate on a debt instrument. In most cases, the risk is focused on the potential for something to occur that makes that rate no longer attractive for the investor. While this type of risk is more directly connected with the risk associated with a bond issue, interest rate risk is also a factor that must be considered when investing in stocks and other types of assets.

There is no real way to avoid at least some interest rate risk with any given type of investment. Choosing to go with a debt instrument that carries a variable rate of interest still has the risk that the average rate will increase to a point above that of the projected amount at the time the transaction is originated, and remain at that point for a significant amount of the life of the debt instrument. At the same time, going with a fixed rate also runs some risk, in that the prevailing interest rate could fall well below that fixed amount, creating a situation where the once attractive rate is actually costing the investor money over the long run.

For this reason, it is important for investors to consider the possible movement of interest rates before actually committing to any type of investment for a longer period. For example, when considering a bond issue that will take ten years to mature, the investor will want to assess interest rate risk by attempting to project the movement of the average rate of interest over that same amount of time. If the projection indicates that the average interest rate will remain more or less stable, then the investor can calculate the amount of return based on that stability and determine if the bond issue is a good investment. Should the projection indicate that the average rate of interest may drop during the life of the bond, that is actually to the benefit of the investor, since the return will be even more attractive.

Interest rate risk is not the only factor that the investor must consider when choosing to buy or sell an investment. General movements in the market that could affect the rate per share of stock, or lead to a bond issue being called early, must also be assessed. Changes in credit risk, or failing to objectively evaluate available data may lead to increased risks that are not necessarily associated with the interest rate itself. Still, taking the time to compare the anticipated return in the form of interest on the investment with the projected movements of the market where the asset is traded will go a long way toward preventing the selection of unwise investments, and keep the portfolio from losing value overall.