What is interest rate risk and why does it matter?

What is interest rate risk and why does it matter?

Subject: Economy

Section: Monetary Policy

Interest rate risk is the possibility of loss to an investor who owns any debt based instrument, such as bond or debenture resulting from an increase in the current interest rate offered for a similar new debt instrument.

The reason for the possibility of loss can be understood by understanding the concept of present value of an investment. When a bond is bought, the price is representative of the present value of the future cash returns it will give. The below illustration explains, the interest rate risk in action:

• Suppose a bond offering 7% interest and having 1 year maturity will give Rs 107 return on maturity, then its current price will be Rs. 100.
• Now suppose the market interest rate rises to 9%, then the owner is naturally in loss as, had he waited he could have invested at the higher rate. This loss is seen in the price decline of the old bonds, here the price of the Rs. 100 bond will drop to Rs. 98.16.
• The above amount Rs. 98.16 is the investment that with the new rate provides the same return as the old Rs. 100 investment at the rate of 7%.

NOTE: Difference between a loan and a bond

• Loan involves one party (lender) transferring a set amount of money (principal) to the borrower (debtor) at an agreed rate. The agreement stays between the two parties till the term of the loan.
• Bond or debenture on the other hand is just a loan that is tradable in the secondary market, just like a share is traded. Its price varies with the movement of prevailing interest rate and with a change in evaluation of the risk associated with it. The lesser the risk associated, the lower is the interest rate of the bond.
• Because bonds are traded, they can earn a negative return for the investor, unlike a loan.

Interest Rate risk in Banking:

• Bank’s face significant interest rate risk, as the ‘banking book’, mainly comprises debt assets. (‘Banking Book’ is the term used for assets on a bank’s balance sheet)
• Interest rate risk may impact the capital base and future earnings of the banks.
• RBI has issued guidelines on Interest Rate Risk in Banking Book (IRRBB), that requires banks to measure, monitor, and disclose their exposure to IRRBB. The guidelines are in sync with the framework issued by the Basel Committee on banking Supervision (BCBS)