Interest rate risk is the risk that a financial instrument's fair value or future cash flows will fluctuate because of changes in interest rates.
Interest rate risk is among many other market risks affecting financial instruments. Market risks include currency risks and equity price risks.
Some typical financial instruments exposed to interest rate risk include money market instruments, debt securities, derivatives, government bonds and borrowings.
It arises from interest-bearing financial instruments recognised in the balance sheet, such as debt instruments held by organisations like investments in government bonds.
A straightforward illustration of how interest rate changes impact financial instruments such as government bonds is that when market interest rates rise, the prices of existing bonds usually fall, while the coupon rate on the bonds remains constant as yields on such bonds go up.
The reverse is the case when market interest rates come down. Therefore, it is clear how changes in interest rates impact the market value of interest-bearing investments held by organisations.
Investors and stakeholders are keen to understand the market value of an organisation's interest-bearing assets and liabilities.
It is essential information organisations must provide under IFRS 7, “Financial Instruments: Disclosures”, for all financial instruments regardless of how they are measured on the balance sheet.
This way, stakeholders can compare the carrying amounts of these financial instruments to their fair value at the reporting date.
The standard also requires organisations to disclose sensitivity analysis for market risks such as interest rate risk.
It is an analysis that shows how changes in interest rates would have impacted the entity’s performance.
This impact would depend on the measurement options applied by each organisation following the classification and measurement of their financial instruments in the balance sheet.
Interest rate risk disclosures can assist organisations with treasury planning because it provides an overview of the adverse financial exposure an organisation faces following changes in market conditions which are usually not within the organisation's control but impact the organisation significantly.
The uncertainty in the environment in which organisations operate today, in which interest rates are regularly changing, makes it pertinent for organisations to provide these disclosures.