What does the term "interest rate risk" refer to?

The term "interest rate risk" refers to the variability in a security's returns that can occur due to changes in interest rates. When interest rates rise, the prices of existing bonds typically fall, resulting in potential losses for investors who hold those securities. Conversely, if interest rates drop, existing bonds may appreciate, resulting in potential gains. This risk is particularly significant for fixed-income securities like bonds, where the cash flows are predictable and fixed over time.

Understanding interest rate risk is crucial for investors, as shifts in interest rates can heavily influence market behavior, investment choices, and portfolio management strategies. This concept also underscores the importance of duration and sensitivity of various investments to changes in interest rates in the context of effective financial planning and risk assessment.