Interest Rate Risk Management

 

Interest Rate Risk Management- Interest rate risk uncertainty is the potential for investment impairments that result from a difference in interest rates. If interest rates rise, for example, the value of a bond or other fixed-income investment will degenerate. The change in a bond’s price given a change in interest rates is known as its duration. Interest rate changes can affect many investments, but it impacts the value of bonds and other fixed-income securities most directly. Bondholders, therefore, carefully monitor interest rates and make decisions based on how interest rates are perceived to change over time.

The risk can be overcome by taking bonds of different durations, and investors may also reduce interest rate venture by hedging fixed-income purchases with interest rate swaps, options, or other interest rate derivatives. Risk can be managed through hedging or diversification strategies that reduce a portfolio’s effective duration or negate the effect of rate changes.

To manage interest rate risk, two methods are used.

• Diversify investments in bonds with different duration: This helps to mitigate the differences in short term and long term borrowing/lending rates. Unsystematic risk can be taken care of by diversification.
• Hedging interest rate using ‘Swap’: Different types of interest rate swaps can be used for either fixed or floating rate of interest rates. Both these techniques minimize the interest rate risk. Systematic risk can be overcome by hedging.

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