Interest Rate Risk

Generally, it is the risk that arises from changes in interest rate which impact the value of interest-bearing securities/ investments and the price of loanable funds. For example, a change in market interest rates affects the value of a fixed-income security: as rates increase, the value of an instrument offering a fixed interest rate decreases (compared to the value of newly issue securities that come with higher rates). For an open position, i.e., a position that is not offset by taking position in other instruments to mitigate the effect of change in interest rates, the holder of such a security will incur an economic loss.

Mitigation of interest rate risk depends on the ability of a holder to perfectly offset the negative effect of such a change in market rates. Even when open positions and offsetting positions seem to neutralize the economic exposure of each other, a great deal of risk may still be there due to an imperfect correlation between the positions, whether those with same maturity across various issuers, or different exposures across the yield curve.