Interest Rate Risk and Hedging Key Terms

Know the buzz words when it comes to interest rate risk and hedging

By M. Krasniak, Freelance Writer/Editor

Interest rate risk is the potential for the value of an investment to change due to changes in interest rates. An example of such an investment is a bond. A bond’s duration measures its sensitivity to interest rates. When interest rates go up, the value of the bond decreases, and vice versa. Bonds with higher duration are more sensitive to interest rate changes. The danger of losing value on an investment because of unexpected changes in interest rates is very real, and requires careful risk management, or hedging. Hedging tools, such as swaps and interest rates futures, are available for a wide variety of interest rates, including Treasury rates, and LIBOR.

Treasury rates

Treasury rates are expected returns on U.S. Government bills, notes and bonds, and come in a variety of maturities. These form the benchmark rates for bonds issued in the U.S. Treasury securities are considered to be free of default risk, and so they bear only interest rate risk. Therefore, they are used to measure interest rate risk for a variety of maturities.
Try: Look to TreasuryDirect for an excellent definition of Treasury rates and how they are calculated.

LIBOR

LIBOR is a popular base-line rate for international debt-related investments. The acronym LIBOR stands for London Interbank Offered Rate, and it's based on the average interest rate that international banks charge each other on short-term loans. It is a very popular rate used for managing interest rate risk.
Try: There is a helpful definition and historical record of LIBOR on MoneyCafe.com.

Term structure

Investments of different maturities have different interest rates. Usually, but not always, higher interest rates are offered on investments with longer maturities. Matching average interest rates to maturities gives a term structure of interest rates. The shape of the term structure gives a great deal of information about future interest rate movements, which can help you understand interest rate risk in the future.
Try: Check out The Financial Pipeline for an excellent discussion of the term structure of interest rates.

Interest rate futures

Interest rate futures make ideal hedging instruments. They are contracts in which a buyer and a seller agree to trade a debt instrument at some time in the future, for a price agreed upon prior to delivery. The value of such contracts is the ability to set the price for future delivery ahead of time. This reduces the risk of adverse changes in interest rates.
Try: BusinessDictionary.com provides a concise definition of interest rate futures. Check out the links to related terms as well.

Duration

Duration is a convenient measure of interest rate risk. Larger values of duration imply greater interest rate risk. This measure is insensitive to the size of an investment, and therefore allows comparison of the risk of a variety of investments. It is important to remember that when interest rates change, the duration may also change.
Try: Investopedia features a comprehensive, easily understandable discussion on duration.

Swap

A swap is another hedging instrument. It entails trading one type of interest rate risk for another. If a firm has debt with payments that vary based on changes in interest rates, a swap allows that firm to trade the debt payment for a payment that is fixed and known over time.
Try: Riskglossary.com offers a great explanation of interest rate swaps, including charts and graphs.