Interest-rate risk
What is Interest-rate risk?
Interest-rate risk is the risk that changes in interest rates or yield curves alter the market value, income, reinvestment return, or funding cost of an investment.
Why interest-rate risk matters
Rates influence bonds, equities, real estate, derivatives, currencies, and liabilities. A fixed-rate bond generally loses value when comparable yields rise, while future coupons can then be reinvested at higher rates. Investors must distinguish the immediate valuation effect from the longer-term income effect and align both with their horizon and obligations.
How it is measured
Duration estimates price sensitivity to a small parallel yield change, while convexity refines the estimate for larger moves. Key-rate duration separates sensitivity by maturity point. Scenario analysis tests parallel, steepening, flattening, and curved shifts. Floating-rate instruments, callable bonds, mortgages, and derivatives require models that reflect changing cash flows or optionality.
Example
A bond portfolio with modified duration of six would be expected to lose roughly 6% for an immediate one-percentage-point parallel yield increase, before considering convexity, income, spread changes, or active trading. The estimate is local, not exact. If the yield curve moves unevenly, maturity-specific exposures determine the actual result.
How to interpret it
State whether the measure concerns government rates, total yield, real rates, or a specific curve. Separate duration from credit-spread sensitivity and compare asset duration with liability or spending horizons. A short-duration portfolio has lower price sensitivity but may face more reinvestment risk if rates decline when principal must be reinvested.
Limitations
Duration assumes a defined relationship between prices and yields and is less reliable for large or nonparallel moves. Embedded options can cause duration to change materially. Rate shifts also affect currencies, credit quality, and issuer behavior. A single duration number can conceal opposing positions at different curve points or across currencies.
Practical checklist
Measure modified and key-rate duration, convexity, income, and exposure to inflation and credit spreads. Test parallel and nonparallel curves in each material currency. Review optionality, hedges, collateral, and funding effects. Reconcile model sensitivities with security cash flows, and monitor whether portfolio duration remains consistent with the benchmark, mandate, liability profile, and intended holding period through time and scenarios.
Also known as: rate risk
Sources and further reading
- What is Risk?, Investor.gov, U.S. Securities and Exchange Commission