Investing Dictionary #2: Interest Rate Risk

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For today’s word of the day, it’ll be Interest Rate Risk. IRR according to Investopedia is the risk that an investment’s value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve, or in any other interest rate relationship. Such changes usually affect securities inversely and can be reduced by diversifying (investing in fixed-income securities with different durations) or hedging (such as through an interest rate swap).

More On Interest Rate Risk

The values of IRR heavily affect the value of bonds better than stocks, the way IRR affects bond is rather much more direct. When Interest Rates rise, bond prices receives a decent decrease and vice versa. The logic and rationale on that are interest rates increase, the opportunity cost of holding a bond marginally decreases. This is because investors are able to comprehend a better yield by switching to other investments that have the higher interest rate.

A definite example is; a 10% bond is worth far more if interest rate decreases, the bondholder then receives a fixed rate of return relative to the market, which offers a low rate of return as the receiving end of the decrease in rates.

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Market Interest Hikes

Like bonds, market interest rate increases when prices on previously issued-income securities as traded in the market decline since potential investors are now more inclined to buy new securities that offer higher rates.

It is only by having lower selling prices that it can pass securities with lower rates become competitive with securities issued after market interest rates have turned higher.

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