Investing involves risk. Investments have their own risk factors and many of these factors fluctuate. One major risk factor is interest rate risk. Interest rate changes have the greatest impact on long maturity bonds, but they affect stocks and other financial instruments as well. Greater interest rate volatility indicates a greater chance of interest rate increases which would cause many asset prices to drop. Thus, the volatility of interest rates creates uncertainty for investors.
Interest Rate Volatility
Interest rates can go up or down. Larger and more frequent movements increase the standard deviation of interest rates, which is also referred to as interest rate risk or interest rate volatility. Greater volatility implies greater uncertainty as to where rates will be in the future, since more, bigger movements might add up and move rates substantially.
Interest Rate Risk
Most investments involve giving up money in the present for the promise of payments in the future. The value of those future dollars in today’s money terms is an interest rate. Higher interest rates imply that today’s money is worth more in the future. Higher rates also imply that an investment that promises fixed payments in the future is worth less in today’s money. Thus, higher interest rates are associated with declining investment prices.
The volatility of interest rates has a direct impact on the risk which investors in fixed-rate bonds assume. Bond prices have an inverse relationship with interest rates. When interest rates increase, fixed-rate bond prices fall. The sensitivity a bond’s value to changing interest rates is called duration. The higher the duration, the more the bond’s price moves in response to interest rate changes.
Many other investments have looser connections to interest rate risk. Stocks become less attractive as interest rates rise, though they are impacted less than fixed-rate bonds on average. Other investment vehicles with fixed-rate returns, like real estate with its long, fixed-rate leases, also would be negatively impacted by interest rate increases.
Portfolio diversification can reduce interest rate risk. Bond portfolios can be composed of bonds of multiple durations to reduce interest rate risk. Stocks, Treasury Inflation-Protected Securities and other asset classes can be added to decrease exposure to this risk.
Joe Escalada is a financial analyst. He earned a Master of Business Administration from the University of California at Davis and has passed all three Chartered Financial Analyst examinations. He has a bachelor's degree from the California Institute of Technology.