Question

What are the two main types of interest rate risk faced by a bank and how each is measured?

Answer 1

Investing in bonds is one of the earning choices for investors, which yields fluctuating interest per annum. Depending on the type and the nature of interest rate, we classify the two main types of interest rate risk as 1) Price Risk and 2) Reinvestment Risk. Price risk is the risk that happens when there is any unexpected price change that happens with the immense loss during the period of bond investment operations. Reinvestment Risk subject to the decision of the investor in switching on to another plan of investment because of the reason for expecting safe returns or high returns after a long time.  

The interest rate risk is calculated by the following formula:-

(Initial original price of the bond - New price of the bond)/New price of the bond.

Let us assume the initial price of the bond is $120. And we assume the New price of the bond is $125.

Then the interest rate risk = (120-125)/125

= -0.04 percent.

Thus we can derive the value of interest rate risk of -0.04% with the new price of $125 as against the former price of $120.