Kathmandu. Interest rate risk refers to the risk of profit or loss or capital of a financial institution or investor when the market interest rate fluctuates. To put it simply, a change in the interest rate also changes the value or income of a bond, loan, or other interest-based investment.
A new loan or bond carries a higher interest rate than a fixed interest rate on a previously borrowed bond. As a result, the market demand and price of the previous bond decreases.
If the market interest rate falls, the interest rate on the previous bond will be higher than the new market interest rate. As a result, both the market demand and the market price of the previous bond increases.
Suppose you buy a bond of Rs 100,000 for 10 years at an interest rate of 5%. If the interest rate of a new bond is maintained at 7 percent, the price of your 5 percent bond will decrease with market demand because no one will choose to invest in bonds with an interest rate of 7 percent rather than a 5 percent interest rate.
If the interest rate on a new bond on the market is 3 percent, the market value of your 5 percent bond will increase.
Similarly, in the case of bank loans, it is beneficial for the bank to increase the interest rate of the loan rather than the decrease. Suppose you take a loan of Rs 1,00,000 from a bank at an interest rate of 10 percent. If the new interest rate in the market is 12 percent, then your loan is earning less interest income for the bank. But if the market interest rate is 8 percent, then the loan amount you take out is more profitable for the bank.
Interest rate risk is basically a risk associated with uncertainty arising from market interest rate fluctuations in the value or earnings of an investment or loan.
