Principles of Finance

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Interest rate risk

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Principles of Finance

Definition

Interest rate risk is the potential for investment losses due to fluctuations in interest rates. It primarily affects bonds and other fixed-income securities, as their values are inversely related to interest rate changes.

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5 Must Know Facts For Your Next Test

  1. Interest rate risk increases with the maturity of a bond; longer-term bonds are more susceptible.
  2. Rising interest rates cause existing bond prices to fall because new bonds pay higher yields.
  3. Duration measures a bond's sensitivity to interest rate changes; higher duration means greater risk.
  4. Callable bonds have different interest rate risks compared to non-callable bonds because issuers can redeem them if rates drop.
  5. Interest rate risk is just one component of overall bond investment risk, which also includes credit/default risk.

Review Questions

  • How does an increase in market interest rates affect the price of existing bonds?
  • What is the relationship between bond duration and interest rate risk?
  • Why do callable bonds have a different level of interest rate risk compared to non-callable bonds?
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