Contemporary Finance

10Interest Rate Risk

10.1 Sources of Interest Rate Risk

The values of loans and debt securities vary as interest rates change. The broad sources of yield curve uncertainty are

• Expected future rates: the current risk-free curve fluctuates with expected future rates;
• Liquidity risk: the cost and risk of exiting, adjusting, or maintaining an investment position;
• Inflation risk: the risk of loss from a rise in the general price level;
• Credit spreads: the risk of default and credit migration losses or the market-clearing compensation for credit risk may change.

Each source of volatility is compensated through a component of the risk premium of the loan or security. Risk premiums are generally positive, making bonds cheaper and increasing prospective future returns, but may be negative for the most sought-after safe assets.

Longer-term rates along a risk-free curve can be decomposed into the short-term rates expected to prevail up to maturity or the expected return from rolling over short-term debt, and a term premium, the additional yield compensating lenders for bearing the interest-rate risk of a longer-term security. The term premium is sometimes defined simply as the observable spread between longer- and shorter-term government bond yields but more generally as the unobservable spread between the long-term nominal rate and the rate implied by the expected path of short-term risk-free nominal rates.

The term premium as well as expected short-term rates fluctuate; aversion to ...