Interest Rate Risk – A risk is any variation from the expected return of an investment on the downside. An interest rate risk implies the risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. Basically such a downside depends on interest rate variations. In general these changes do not affect securities directly and can be minimized by diversifying (investing in fixed-income securities with different durations) or hedging (e.g. through an interest rate swap).
Those who invest in stocks are not much bothered by the interest rates. However those who invest in Fixed Income (specifically bonds) are exposed to risk as the yield/price of the bond is highly correlated to the prevailing interest rates in the markets. Interest Rate has an inverse relation with the price of a bond. A person having a long position in a bond would benefit when rates go up. Hence for him the risk arises when the rates are expected to go up.
No other entity is as vulnerable to interest rates risk as banks. Banks face basis risk (assets and liabilities are based on different rates moving in different direction), yield curve risk (bank earnings by taking advantage of difference in short term and long term rates does not follow the market expectancy principle), reinvestment risk (related to the cost of capital of bank, like bank can borrow when rates are high, but when it lends prevailing rates become low) & option risk (prepayment options associated with a loan, similar to a putable bond).
The Dual Perspective – The risk for the lender of money is that the borrower may not pay back the loan. Thus, interest provides also a certain compensation for bearing risk. The borrowers pay interest because they must pay a price for gaining the ability to spend. So the risk for a borrower is that interest rate may increase and he will have to pay higher amount of interest in future than what the present rates show him. Interest can thus be considered a cost for one entity and income for another.
Factors Affecting Interest Rates – Interest rate levels are a factor of the supply and demand of credit; an increase in the demand for credit will raise interest rates and vice versa. Conversely, an increase in the supply of credit will reduce interest rates while a decrease in the supply of credit will increase them. Inflation is also an important factor that affects interest rate levels. The higher the rate of inflation, the more interest rates are likely to rise. This occurs because lenders will demand higher interest rates as compensation for the decrease in the purchasing power of the money they will be repaid in the future. The decision of whether or not to change the rates however finally depends on Government which acts through its central bank to bring about changes in interest rates.
The Monetary policy and RBI – In India the central bank RBI decides when and by how much to change the prevailing rates chiefly the repo rate, SLR and CRR. These figures in turn affect the rates banks in India use to lend to retail and corporate clients. A periodic review of the Economy is conducted and the rates are altered accordingly. For example the current inflation would tend to bring the rates to higher side but the fears of double dip recession and stagnated economic growth might prevent this to happen. The prime motive was to sustain the liquidity levels. RBI also announced a buyback of government bonds to increase the liquidity in the system. This marks the first pause in key rate increases in this calendar year, during which they have been raised six times to fight inflation. However in January the rates may go up again as Inflation seems to head north. This will totally depend on how the markets react to the policy changes. Currently the repo and reverse repo rates are unchanged at 6.25% and 5.25% respectively.
Risk Management – To overcome interest rate risk, two tools are employed. One is to diversify investments in bonds with different duration; this takes care of differences in short term and long term borrowing/lending rates. Unsystematic risk can be taken care of by diversification. Systematic risk can be overcome by hedging.
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