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What Is Interest Rate Risk?
by Alfred Sarkissian
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Overview
Interest rate risk refers to the magnitude and likelihood of unanticipated changes in interest rates that impact the costs of raising capital from various sources as well as demand for the product. It is considered as one of the sources of macroeconomic uncertainty a business enterprise faces (Oxelheim and Wihloborg, 2008, p. 26). Interest rate changes impact businesses, consumers and investors (Mladjenovic, 2006, p. 47).
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Businesses
Rising interest rates have an adverse impact on companies that have a large current debt or need to borrow more because with the rise in interest rates, the cost of borrowing rises. This in turn reduces a company's profitability and ability to grow. When the company's profits drop, its stock becomes less palatable for investors, and the stock price falls (Mladjenovic, 2006, p. 48).
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Customers
A company's bottom line depends on selling products and services. The financial health of customers (particularly other businesses) has a direct impact on the company's ability to increase sales and earnings. If the customer is in debt and pays more interest it will have less disposable income to spend on purchases (Mladjenovic, 2006, p. 49).
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Investors
Faced with rising interest rates, investors resort to one of the following decisions (Mladjenovic, 2006, p. 49):
1) Investors may sell their shares in interest-sensitive stocks (e.g. electric utilities, real estate and the financial sector). While increase in interest rates can hurt these sectors, the reverse can also hold. Falling interest rates can boost these industries.
2) Investors who prefer increased current income (versus waiting for investments to grow and then sell them) are drawn to investments that have a higher return rate. Higher interest rates can cause investors to switch from stocks to bonds or bank certificates of deposit (Mladjenovic, 2006, p. 49).
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Stock Prices
High or rising interest rates can have a negative impact on the investor's general financial standing. When investors are struggling with burdensome debt, they may sell some stocks to repay high-interest debt. Large stock sell-offs can hit stock prices hard (Mladjenovic, 2006, p. 49).
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Monitoring
Because of the impact of interest rates on stock portfolios, successful investors regularly monitor interest rates at the level of the general economy as well as their specific situation (Mladjenovic, 2006, p. 50). Monitoring interest rates can also help companies and consumers in timing their borrowing.
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Diversification
Although stocks are a popular long-term investment choice, investors should maintain a balanced portfolio including money market (i.e. market for short-term debt) funds, savings bonds and bank investments. Variable-rate investments like these do well when interest rates are high, thus hedge the investment portfolio against interest rate hikes (Mladjenovic, 2006, p. 50).
