## [sbinews] What is interest rate risk? (Business Line)

• From: rajendra.pai@xxxxxxxxx
• To: sbinews@xxxxxxxxxxxxx
• Date: Thu, 04 Dec 2003 06:58:28 +0500 (IST)

```What is interest rate risk?
B. Venkatesh

IN THE latest Report on Trends and Progress of Banking in India, the Reserve
Bank of India has cautioned commercial banks of interest rate risk. What is
this risk?

Suppose the market demands a 5.5 per cent yield on a 10-year bond. If the
coupon rate is also 5.5 per cent, the bond will trade at par, which is Rs 100.

But what if the market demands a yield of 6 per cent on a 10-year bond? There
will be no demand for the 5.5 per cent 10-year bond.

So, the price of the 5.5 per cent coupon 10-year bond will decline in value
such that it yields 6 per cent. Those who hold bonds, therefore, run the risk
of interest rate increase. This risk is called the interest rate risk.

Note the inverse price-yield relationship. Bond prices rise when interest rate
decline, and prices fall when interest rate increases.

Now, interest rate risk is dependent on the maturity of the bond; longer the
bond maturity, higher the interest rate risk. So, the 5.5 per cent 10-year bond
will decline more to yield 6 per cent compared with a 5.5 per cent five-year
bond. Why?

When you buy a bond, you receive interest every year and the redemption price
on maturity. The bond price is, hence, a function of the present value of these
cash flows. When the market demands higher yield, we have to use a higher
discount factor to calculate the present value of cash flows.

In the case of a 10-year bond, we have to use the higher discount factor for 10
years.

For a five-year bond, a higher discount factor has to be used only for five
years. But higher discount factor means lower price. That is why longer
maturity bonds are more sensitive to increase in interest rates.

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