Handbook of Market Risk

Chapter Nine

Fixed Income and Interest Rate Risk

Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years.

—Warren Buffett

Interest rates are a key component in many market prices and represent an important economic barometer. Factors that influence the level of market interest rates include:

• Expected levels of inflation
• General economic conditions
• Monetary policy and the stance of the central bank
• Foreign exchange market activity
• Foreign investor demand for debt securities
• Financial and political stability

Fixed-income securities, which include bonds, treasury bills, and commercial papers, pay a fixed rate of interest. The value of the funds that purchase fixed-income securities will rise and fall as interest rates change. For example, when interest rates fall, the value of an existing bond will rise because the coupon rate on that bond is greater than the prevailing interest rates. Conversely, if interest rate rises, the value of an existing bond will fall.

The yield curve is a graphical representation of yields for a range of terms to maturity. Since current interest rates reflect expectations, the yield curve provides useful information about the market's expectations of future interest.

Interest rates determine the discount rate for all financial assets, so it is of crucial importance to asset values. Interest rates affect equities (via company debt or bank earnings, for example), convertibles, bonds, floating rate notes, inverse floating ...