Interest rate risk

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Interest rate risk is the risk that the relative value of a security, especially a bond, will worsen due to an interest rate increase. This risk is commonly measured by the bond's duration.

A bond is a part of a loan to an entity. Someone buying a bond when it is first issued can be compared to someone putting money in a certificate of deposit (CD). It is locked away and every quarter a check is sent to the lender for the interest paid, at a certain interest rate (for example 5 %). If the lender holds the bond until it matures (for example after a year), then the lender gets his money back plus 5 % interest and there is no interest rate risk. Unlike a CD however, a person can't terminate their bond early if they need their money (with a CD one can do this with a penalty). The only thing a person can do is sell the bond to someone else. Assuming interest rates on comparable bonds have remained the same, a person is likely to buy the bond at a discounted price which reflects the interest payments already given to the seller (so that the seller does not lose any money). If the interest rates on other similar bonds are now being issued at 7 %, there would be no reason to buy a bond that only makes 5 %, so the seller must sell the bond at a discount (and lose money) which roughly means the buyer who buys it earns 7 % if he holds it until it matures. The possibility of a loss due to a scenario like this is called interest rate risk.

The other side of the coin is that when interest rates are lower, the owner of the bond can sell it to someone at a premium because that will be just as good if not a better return than what the other person can get new.

The price differences in the values of bonds caused by these interest rate changes are thought to be at present more volatile as a class than stock price changes. This was especially true after Paul Volker let interest rates float freely in the early 1980's.

Horizon Risk occurs primarily with fixed income securities, such as bonds, when the buyer locks in a rate for an extended period of time and the expected return on the investment decreases as a result of changes in the inflation rate over time.