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B. Venkatesh

IN THE latest Report on Trends and Progress of Banking in India, the Reserve Bank of India has cautioned commercial banks of interest rate risk. What is this risk?

Suppose the market demands a 5.5 per cent yield on a 10-year bond. If the coupon rate is also 5.5 per cent, the bond will trade at par, which is Rs 100.

But what if the market demands a yield of 6 per cent on a 10-year bond? There will be no demand for the 5.5 per cent 10-year bond.

So, the price of the 5.5 per cent coupon 10-year bond will decline in value such that it yields 6 per cent. Those who hold bonds, therefore, run the risk of interest rate increase. This risk is called the interest rate risk.

Note the inverse price-yield relationship. Bond prices rise when interest rate decline, and prices fall when interest rate increases.

Now, interest rate risk is dependent on the maturity of the bond; longer the bond maturity, higher the interest rate risk. So, the 5.5 per cent 10-year bond will decline more to yield 6 per cent compared with a 5.5 per cent five-year bond. Why?

When you buy a bond, you receive interest every year and the redemption price on maturity. The bond price is, hence, a function of the present value of these cash flows. When the market demands higher yield, we have to use a higher discount factor to calculate the present value of cash flows.

In the case of a 10-year bond, we have to use the higher discount factor for 10 years.

For a five-year bond, a higher discount factor has to be used only for five years. But higher discount factor means lower price. That is why longer maturity bonds are more sensitive to increase in interest rates.

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