Interest Rate Risk Made Easy

Interest rate risk is another risk you have to bear before you sell the bonds prior to the maturity date. Interest rates have an inverse effect to bond prices. As when interest rate is high, outstanding bonds price will fall, and if the interest rate in low, the bond price will rise.

The bond's duration is usually used to measure this particular risk. In other words, it is risk to the possible earnings or to the market value of a given portfolio attributable to uncertain future interest rates.

Short term bonds that are mature faster can be less affected by the movements in interest rates. However, they are normally paying very low return.

Conversely, longer term bonds will be subjected to the risk of a higher interest rate, but pay higher returns.

There are essentially two different two ways in which one can approach Interest rate risk. These would be a book value perspective and what is called a market value perspective (which is sometimes referred to as an economic perspective).