What is interest rate risk?

For a business the exposure is usually simple: how much of the debt sits on a variable rate and how much is fixed. When market rates rise, the repayment on every variable facility rises with them, from an overdraft to equipment finance, and that lands in cashflow within a statement or two. Fixed contracts are insulated until they roll off, so the risk turns up later, when the facility reprices at whatever the market is doing then.

There is a second side to it: what a rate move does to the value of a fixed-rate instrument. Rates and prices move inversely, so when yields rise the market value of a fixed-rate bond falls, and when yields fall it rises. The response is convex: for a bond with positive convexity, the price gain from a fall in yields is larger than the price loss from an equal rise. A floating-rate item feels it in the interest paid or earned instead of in its price.

The measures come from bond maths. Macaulay duration is the weighted average time, in years, until a bond's cash flows arrive. Modified duration converts that into the approximate percentage price change for a small parallel shift in yield. DV01 (or PV01) turns it into dollars: the change in value for a one basis point move, roughly modified duration times price times 0.0001.

Convexity is the second-order adjustment that captures the curve in the price response. It improves the estimate for larger moves, long maturities and bonds with embedded options. Beyond single-point measures, firms run scenario analysis and stress tests: parallel shifts, steepening and flattening, and basis shocks, plus historical and hypothetical tail events.

Exposure looks different across the economy. For a company, the fixed versus floating mix of its debt sets the exposure, and changes in borrowing rates flow through to project costs and working capital. Retail investors and bond funds are exposed mainly through portfolio duration, credit spreads and reinvestment timing. Banks watch net interest income and the economic value of equity. Insurers and super funds see their liabilities move with discount rates and use duration matching, long bonds or swaps.

The usual mitigants are duration matching, laddering maturities, interest rate swaps, bond futures, forward rate agreements, and caps, floors and options that give one-sided protection for a premium. Choosing between them comes down to what the protection costs, how much flexibility you give up, and how the accounting and tax treatment lands. Setting up a hedge and drafting the paperwork is specialist work, so most businesses take it to a risk adviser and their accountant.