Methodology

Stocks

Module 2

Interest Rate Risk

Interest rate risk refers to the interest rate in a particular country increasing. This is a problem for companies as it becomes more expensive for them to borrow money, limiting their ability to fund new projects or to employ more people.

 

It will also mean that borrowing money is expensive for consumers, leading them to cut their spending, reducing the amount of sales that companies make.  Therefore, if borrowing money becomes more expensive, it can have a significant impact on the profitability of a company. This tends to have a negative impact on most stocks.

 

The only exception to this would be when it comes to finance companies, which would earn more profits when they borrow money to other companies or individuals. The stock price of finance companies will likely rise when interest rates increase.

Diversifying Sectors

In terms of managing interest rate risk, diversification is the key. Investing in a diverse portfolio will offset the impact of interest rate rises.

 

A key way to diversify away interest rate risks is to invest in a wide range of different sectors. This is the case as different sectors are impacted by interest rate rises (or declines) in different ways. As mentioned, finance stocks (i.e. banks) are likely to increase in value, in response to interest rate rises. Therefore, diversifying a portfolio with finance stocks, alongside stocks from other sectors, will offset the effects of interest rate risk to some extent. 

 

Examples of stocks that could benefit from interest rate rises include banks, stock brokers, insurance companies and gold miners.

Diversifying Countries

Another way for an investor to reduce their exposure to interest rate risk is to invest internationally, as interest rate changes are often specific to a particular country. An investor could invest in foreign stock markets to access investments that operate in a particular country. For example, a British investor would have to invest in the New York Stock Exchange if they wanted to invest in Verizon, which is a company that only operates in the United States. This would allow the investor to benefit from the interest rate risk in another country, especially as Verizon only operates in the United States.

 

Alternatively, to further protect themselves, an investor could invest in companies that operate in several countries. This would benefit the investor as the company could borrow money in the country that offers the most favourable interest rates, reducing its exposure to rising interest rates. As a result, the investor would be less exposed to the damaging effects of rising interest rates in their own country.

 

Of course, we now live in a globalised world where interest rates often change in tandem with other countries. However, diversifying sectors or countries can still have the benefit of protecting investors from rising interest rates – at least to some extent.

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