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Understanding Inverse Relationships
By Julia O’Neal; MA, CPA
Interest Rate Risk [IRR] refers to the tendency of all investments to rise as interest rates decline and fall as interest rates rise. This inverse relationship is common among all investments, although not to the same degree.
Pure Interest Rate Movements
A U.S. Treasury security best demonstrates the pure interest rate move.
The risk is present with other investments as well, since the discount rate—the required rate of return used to place a value on an asset—in part consists of the return available from a default-free investment.
History shows that when the average level of interest rates rises, absolute volatility also rises.
Assessment
When looking at interest rate risk and other investments, it becomes important for physician-investors to look at the other component of the discount rate or the required risk premium over and above the risk-free rate.
For example, in the case of high-grade bonds or utility equities, the default rate dominates the total discount rate, making interest rate risk more influential.
For other investments, such as junk bonds or growth equities, the risk premium required has a much greater influence, somewhat reducing pure interest rate risk.
Conclusion
Are you willing to accept interest rate risk in your investing portfolio; how much IRR and for how long?
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Filed under: Investing | Tagged: Investing Basics |
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