Question

3. Define and discuss interest rate risk. What are the two risk components of interest rate risk and how do these interact with each other?

4. Explain how and why the U.S. forward exchange rates are related to short-term interest rates in the United States and Germany.

Answer 1

Q-3)

The interest rate risk is the risk that with the change in the interest rate the price of the asset may fall and the overall portfolio will be negatively affected. As interest rate rises the price of the bond falls. The two components of the interest rate risk are the price risk and the reinvestment risk. There is an inverse relationship between the interest rate and the price of the bond so as the interest rate increases the bond price decreases. The reinvestment risk is the risk related to the fall in interest rate. If there is significant fall in the interest rate then the borrower might choose to refinance the loan at lower interest rates and the lender will have to reinvest the proceeds at lower interest rate. The price risk and reinvestment risk normally arises in the opposite scenario, one when the interest rate is rising and another when the interest rate is falling.

Q-4)

The forward exchange rates are related to interest rate as the exchange rate is between two currencies and the interest rate can affect the demand and supply of those currencies. For example lets say the short-term interest rates are high in the US so more investors would be attracted towards investing in US and that will increase the demand for the US dollar and dollar will appreciate and lets say the similar situation is with the other currency Euro where the Interest rates are high so more investors would be attracted towards investing in Euro and the Euro will appreciate vis-à-vis dollar. Hence the forward exchange rates can be significantly affected by interest rates.