Interest Rate Risk

David Mieczkowski, PhD, and Mido Shammaa, CFA, FRM

Fixed income is all about cash flows and the time value of money. Interest rates are a way of expressing the latter, so interest rate risk is concerned with ways in which the time value of money may change in the future. It’s probably not necessary to explain why understanding interest rate risk is such a big deal, but just in case you haven’t stared into the abyss in a while, consider this: according to the Bank for International Settlements, notional amount outstanding of interest rate contracts, forward rate agreements (FRAs), swaps, and options totaled over US$550 trillion, with a mark-to-market value of over US$13 trillion, as of June 2011. Given that the U.S. gross domestic product (GDP) is about $15 trillion, that’s a lot of money! Now, if you’re still wondering what all the fuss regarding interest rate risk is about, you’re probably a gold bug who has wandered into the wrong chapter.

With all that interest in interest, you probably wouldn’t be surprised at the size of the industry devoted to nothing but understanding interest rate risk. Indeed, it could be said that interest rate risk was the first type of financial risk that people tried to manage. The world didn’t get its first stock certificate until the 1600s, whereas the First Council of Nicaea was already setting limits on high yield investments in the year 325, by forbidding the early Catholic Church from lending at rates higher than ...

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