Market risk (also incorrectly called interest rate risk) is the risk of bond rates rising and the holder making a capital loss. This is the same as the price of bonds falling, because the two are inversely related. The risk increases as the term of the bond increases. This risk cannot be avoided except by using the derivatives market to hedge, but the price of derivatives detracts from the yield enjoyed.
The two main features of bonds that impact on rate/price are:
- Term to maturity
- Coupon rate.
In general, the longer the bond and the lower the coupon rate, the more price sensitive it is to changes in the market rate.
Because of the abovementioned features of bonds, investors require a measure of the price sensitivity of bonds in relation to changes in market rates. The measure developed for this purpose is called duration, and this will be discussed in some detail in a separate section.
Market risk is the chief risk faced by bondholders.