On the other hand, a decrease in market yield induces a price increase that results into
capital gain if the investor liquidates his bonds. However, if the bond is held till its
maturity, there is no risk resulting from market variations.
- Income Statement Risk (or Revenue Risk)
This risk is observed when interest rate fluctuation decreases profits either by increasing
financial charges or by reducing financial income. For example, if an Indian company
has borrowed US dollars at the floating rate of interest and wants to renew the debt, the
interest charge will increase since the new rate would normally be higher. Financial
charges appearing in the income statement would increase. Similarly, another company
that wants to borrow French francs after six months fears an increase in French rates; it
would suffer a loss of opportunity by not borrowing now.
The enterprise that issues fixed-income bonds pays interest which is not affected by
changes in market conditions. If interest rates decrease subsequent to the bond issue, the
issuer suffers a loss vis-à-vis its competitors.
The situation is identical for an investor who has bought fixed income bonds. If the rate
goes up, once the purchase has been done, the investor suffers a loss in comparison to
those investors who had waited for rate increase. On the other hand, if the rates decrease,
subsequent to the purchase, the investor makes a gain in his income vis-à-vis other
operators who did not buy the security at the opportune moment.
Interest rate risk is measured by sensitivity and duration.
The value of sensitivity depends upon several factors:
- Life of the security;
- Interest rate on the security;
- Market interest rate.
Bond prices vary in opposite direction to that of interest rate variation. When two bonds
differ only in terms of their interest rates, the one having the lower coupon will vary more
for the same variation of market interest rate.
When two bonds differ only in terms of their maturity, the one having the longer maturity
will vary more for the same variation of the market interest rate.
For every bond, a given increase in the interest rate results into a smaller variation of
price than an identical decrease in the interest rate.
For a given percentage increase or decrease of interest rate, and everything else being the
same, price variation is higher for the security with the lower coupon.