What is interest rate risk?

Interest rate risk refers to the potential for fluctuations in interest rates to adversely affect the value of financial instruments. This risk is particularly relevant for fixed-income securities such as bonds, which can lose value when interest rates rise, because existing bonds with lower interest rates become less attractive to investors. As a result, the market value of these older bonds decreases, reflecting an inverse relationship between interest rates and bond prices.

Understanding interest rate risk is crucial for financial professionals, especially in treasury management, as they must make decisions regarding investments, financing, and cash management that could be influenced by changes in interest rates. This risk can also impact a company's cost of borrowing; as interest rates rise, the cost of new debt increases, potentially affecting the firm's overall financial health and strategy.

The other options do not accurately define interest rate risk. Options concerning cash reserves and missed interest payments are related to liquidity and credit risk, respectively, rather than specifically addressing the impact of changing interest rates on the value of financial instruments.