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Interest rate risk

Interest risk is a profit risk arising from adverse interest rate fluctuations that result in higher interest costs or lower income from investments and proceeds from loans granted.

A firm going into another firm 's takeover would, after a while, be at interest risk if that acquisition was borrowed rather than by issuing shares.

Banks and other financial institutions that have significant interest-earning funds are usually more at risk. If the firm has taken significant loans, inefficient interest rate risk management could bring the firm to the brink of bankruptcy.

Changes in interest rates entail several types of risk.

  • Risk of higher interest costs or lower investment income than expected due to fluctuations in overall interest rates.
  • Risk associated with such a change in interest rates following a loan decision that does not provide the lowest interest expense.
  • Risk of making a loan or investment decision that does not result in the highest income due to changes in interest rates that have occurred since the decision was made.
  • The risk that interest expense on a fixed interest loan will be higher than that of a floating interest loan, or vice versa. The greater the mobility of the rate (the regularity of its changes, their nature and size), the greater the percentage risk.

The risk to the borrower is dual in nature. Receiving a fixed rate loan, it is at risk due to falling rates, and in the case of a freely fluctuating rate loan it is at risk due to their increase. Risk can be reduced by predicting in which direction interest rates will change during the term of the loan, but this is difficult to do. Risk to the lender is the mirroring of risk to the borrower. To make the most profit, the bank must provide loans at a fixed rate when interest rates are expected to fall and at a floating rate when they are expected to rise. An investor can place funds on short-term or fluctuating interest rate deposits and earn interest income. The investor should prefer a fixed interest rate when interest rates are expected to fall and fluctuating when they are expected to rise. The change in interest rates depending on the term of the loan can be expressed using the interest income curve. The normal interest income curve is considered an ascending curve. It means that interest rates for long-term loans are usually higher than for short-term loans, and thus compensate creditors for their longer-term linkage and higher credit risk in the case of long-term loans. The bank 's view of percent risk differs from that of its corporate clients. The percentage risk to financial institutions is the basic and the risk of a time gap.

The underlying risk is related to changes in the interest rate structure. The underlying risk occurs when funds are taken at one interest rate and loaned or invested at another. The risk of a time gap arises when loans are received or provided at the same base rate, but with some time gap in their revision dates on loans taken and granted. Risk arises from the timing of interest rate revisions, as they may change between revisions.