Interest Rate Risk

Lesson

Interest rate risk is the potential for investment losses due to changes in interest rates. It is a systematic risk affecting all market investments, not just specific securities or industries.

Practice Question #1

Which of the following is a type of systematic risk?

A) Interest Rate Risk

B) Credit Risk

C) Liquidity Risk

D) Currency Risk

Select an option above to see an explanation here.

A) Interest rate risk is a systematic risk affecting the entire market. B) Credit risk is specific to individual borrowers and their ability to repay debt. C) Liquidity risk is specific to individual investments and their ability to be sold quickly. D) Currency risk is specific to investments denominated in foreign currencies.

Terms

Interest Rate Risk:: The potential for investment losses due to changes in interest rates.
Systematic Risk:: Risk that affects the entire market, not just specific securities or industries.
Reinvestment Risk:: The risk that an investor will have to reinvest interest or principal at a lower rate than the original investment.

Practice Question #2

What is the primary reason that bond prices decrease when interest rates rise?

A) Inflation Risk

B) Reinvestment Risk

C) Yield Curve Shifts

D) Increased Attractiveness of New Bonds

Select an option above to see an explanation here.

A) Inflation risk is the risk that the purchasing power of an investment will decrease, not the primary reason for bond price decreases. B) Reinvestment risk is the risk of reinvesting at a lower rate, not the primary reason for bond price decreases. C) Yield curve shifts can impact bond prices, but the primary reason is the increased attractiveness of new bonds. D) When interest rates rise, new bonds with higher interest rates become more attractive, causing the value of existing bonds to decrease.

Historical Example

In the early 1980s, interest rates in the United States reached record highs, with the Federal Funds Rate peaking at over 20%. This led to a significant decline in bond prices, as investors demanded higher yields to compensate for the increased interest rate risk. As a result, many investors who held long-term bonds experienced substantial losses during this period.

Practice Question #3

Which of the following measures a bond's sensitivity to interest rate changes?

A) Duration

B) Yield to Maturity

C) Coupon Rate

D) Par Value

Select an option above to see an explanation here.

A) Duration measures a bond's sensitivity to interest rate changes. B) Yield to maturity is the total return an investor will receive if they hold a bond to maturity. C) Coupon rate is the annual interest payment on a bond. D) Par value is the face value of a bond, typically $1,000.

Real-World Example

An investor purchases a 10-year bond with a 3% annual interest rate. If interest rates rise to 4%, the value of the bond will decrease as new bonds with higher interest rates become more attractive to investors. The investor may experience a loss if they need to sell the bond before maturity.