Interest rate risk is the possibility that rate changes worsen an asset's value or future receipts and payments. To understand it, separate promised interest, market price, the rate-reset date and the final debt repayment date. Borrowers and lenders can experience the same change differently. A floating rate or a hedging contract does not automatically remove every related risk.
Imagine a bond that pays no interim coupons, or interest payments. Our model repays 100 USD, US dollars, in exactly a year, without default or costs. We ask what that future amount is worth today. With an annual required yield of 5%, price is 100/1.05, about 95.24; at 10%, it is 100/1.10, about 90.91. Converting future money into present value is called discounting. We compare the same instant and remaining term, not the price a year later. If the market requires a higher return for waiting, it will pay less for the same future payment. Other risks also affect an actual trade. [1]
A coupon is an interest payment agreed for a bond. In another example, the bond has principal of 100 USD, the contractual repayment amount apart from coupon interest, and a fixed annual coupon of 4%. The coupon rate applies to this face amount, not automatically to today’s purchase price. The contractual payment therefore remains 4 even when a new market rate reaches 7%. But the price at which you can sell the original bond may change: a buyer compares its payments with today's alternatives. Holding to maturity does not remove issuer default, inflation or the need for money earlier. The issuer is the party that issued the bond. On the borrower's side, fixed interest does not rise by itself before an agreed change or refinancing, which replaces old debt with new funding. [1]
Knowing that interest floats is not enough; we need its formula and calendar. TreasuryDirect describes US Floating Rate Notes (FRN), government securities with variable interest, using an index based on 13-week Treasury bills, short-term government debt securities. A spread is added and stays fixed for the issue's life. The index resets weekly, interest accrues daily and is paid quarterly. A rate change and money arriving in an account therefore occur at different times. Our simplified index of 3% plus a spread of 2% gives 5%; with the index at 5%, the rate becomes 7%. These are not current FRN quotes. A particular payment also depends on day counts, the contractual amount and the instrument's rules. [3]
How strongly might a price react to a yield change? Duration helps estimate that sensitivity. A separate model has modified duration of 4. For a small parallel rise in yields of 1 percentage point, meaning the same shift across remaining terms, it estimates price change as −4×0.01 = −4%. This is a first-order approximation, not a guaranteed exact loss. A percentage point is the direct difference between percentage rates. Larger changes, price-yield curvature or contractual rights to alter payments can change the outcome. Rates for different terms need not move together either. Do not confuse duration with the years remaining until principal repayment. [2]
A higher bond price does not tell us the rate available when we reinvest money received. Our coupon of 4 USD reinvested for a year at 5% earns 0.20; at 1%, it earns only 0.04, before costs. Reinvestment means putting returned or earned money to work again. Falling rates may therefore raise an existing bond's price while reducing income on new money. With a callable bond, the issuer also has a contractual right to repay early under specified conditions. The investor may then need a new home for the money just when rates are lower. Check the contractual call price and dates; falling rates do not trigger an automatic redemption of every bond. [4]
An interest-rate swap is an agreement to exchange specified interest payments. Our borrower pays index A plus 2% on a loan and receives index B through a swap in exchange for a fixed payment of 3%. With matching notionals, periods and A=B, the net cost is 5% before fees. Notional means the amount used to calculate the payments. If A−B = 1 percentage point, cost becomes 6%. Different indices can therefore leave risk even when a firm says it is hedged. Mismatched amounts or end dates can matter too. Check the swap counterparty and possible payments required as collateral. Bank for International Settlements (BIS) material describes a bank framework, not one retail customer's contract. [5]
A nominal return describes the change in money; a real return considers what it can buy. Our annual total nominal return is 5% with inflation of 3%. The more precise purchasing-power change is 1.05/1.03−1, about 1.94%. Simply subtracting 5−3 = 2% is a useful approximation, not exact compounding. Both figures must cover the same period. Distinguish inflation expected when deciding from inflation that actually occurred. Taxes and fees can change the result further; a positive interest rate alone does not tell us how much purchasing power increased. [6]
Imagine a company holding 1 BTC with debt of 100 USD. If its contractual rate resets from 4% to 7%, annual cost on unchanged principal rises from 4 to 7. The amount of BTC need not have changed at all. The debt has its own currency and terms; simply holding bitcoin does not pay the lender a coupon. The company must find interest money elsewhere, while the reserve may carry its own price risk. This example does not imply a mechanical direction for BTC's price after rate changes. It illustrates the difference between financing costs and the market value of what the company holds. [7] [1]
For the clearest picture, read this entry together with Credit risk, Debt maturity, Refinancing risk, Leverage. The reverse links also lead from Natural Rate of Interest, Fair value accounting.