Interest Rate Risk

Interest rates affect consumers on a retail level as they influence credit card purchases, home loans, business loans, as well as investments that pays a fixed rate.  On the institutional level, interest rates are the key components in which large institutions fund their daily cash flow.  Loans between banks as well as overnight loans to large corporation allow companies to fund their daily liabilities.

Interest Rate Markets

The debt market is a global market as well as a local market.  Most investors view interest rates as the rates in which a sovereign government borrows money.  In general, these are the most liquid interest rates, but are far from the only rates traded in the global market place.  There is debt issued by municipalities, debt issues by corporations, and debt issued on homes and cars.

Interest rates move as a function of monetary policy and market forces.  Monetary policy is the process by which the monetary authority of a country, which is usually the central bank, controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability.

The official goal of monetary policy includes dual mandates such as relatively stable prices and low unemployment. In other countries the focus is solely on price stability. Monetary theory provides insight into how to manage optimal monetary policy. It is referred to as either being expansionary or contractionary.

Central banks will be dovish in times when growth is slow and prices are stable, and in turn will lower rates.  Central banks will be considered hawkish when growth is robust and prices are rapidly moving higher.  In these times the monetary authorities will increase interest rates.  By changing interest rates, the central banks are changing the levels at which banks lead to one another as well as, the rate at which they will lend to banks.  In the US for example, this rate is called the Federal Funds Target Rate, and the discount rate respectively.

The changes that a central bank makes to the Federal Funds rates (in the US for example), will generally only effect short term interest rates.  Longer dated rates are influenced by market forces.  This means the rates at which the US government can borrow for 2-5-10 and even 30 years will be created by “the market”.

Changes in Rates

Changes in interest rates are generally described by the change in a basis point which is 1 thousandth of a percent.  There are 1000 basis points for every percent change in a yield. When describing the interest rate risk of a portfolio or financial instrument, the nomenclature refers to the dollar value per basis point, which is commonly written as DV01.

Understanding interest rate risk will give you insight into other products that are affected by changes in interest rates.  Stocks, commodities and currencies all have some exposure to changes in interest rates which keep the capital markets interdependent.