What to expect when interest rates changes

Being an international investor with a well diversified portfolio, you should be aware of interest rate variations.  

Before you analyze the effects in your portfolio, it is important to understand who changes the reference interest rates and why. 

The interest rate, as one of the instruments of the monetary policy, may be amended by the central banks. I am talking about the FED and ECB and other bank regulators. 

An increase of the interest rate suggests a contractionary policy, and a reduction of the interest rate suggests an expansionary policy. 

But the initial question remains to answer, what happens to my portfolio? 

To answer that question we will have to analyze the question from various perspectives: 

-What’s the new return required by the investor to invest in a particular stock (risk premium)? 

One of the ways used to calculate the required return for a stock is the CAPM method.

A change in the reference interest rate will produce a change in the investor’s required return. 

When we change the value of the expected income, a rational investor will evaluate if the market presents other investments, more attractive and profitable. It can also motivate a change in the portfolio’s proportion between stocks and bonds. 

What’s the effect on bond’s investments? 

For an investor who already holds a bond investment, and knowing that the price equals the sum of all cash flows discounted at a given rate (yield to maturity), a change in the reference rate will also change the discount rate and affect the bond’s price. Therefore, a rise in interest rates will cause the bond price to go down and vice versa. 

However, if the investor holds the bond until maturity, the bond’s price will be 100% (called a “pull to par” effect). 

-What is the currency effect when reference interest rate changes? 

Having foreign investment, a change in the reference interest rate will affect the value of the quotation, as for example, EUR/USD par, and have positive or negative effects on your investments. 

The income of a foreign financial asset can be calculated using the following formula (1 + asset Income) * (1 + currency Income) -1. 

According to the international Fisher effect (and keeping everything else constant) if interest rates changes 1%, exchange rates will vary the same amount but in reverse. In other words, if I am an European investor and have an USD investment, when the American interest rate rises, the dollar will appreciate against the euro, having a positive effect in my portfolio. 

You can now understand that a change in the interest rate will have an effect on your portfolio and it requires monitoring.

I also present you with my own portfolio model that you can access here.

The Intelligent Investor portfolio is a custom-made portfolio, accounting for my risk tolerance and my financial goals.

I use the Modern Portfolio Theory and Investment Analysis (mean-variance analysis) to achieve the proportion-weighted combination of the constituent asset’s, but with the condition to go long only (no short sales).

To learn more, check The Intelligent Investor Portfolio report.

 

The Financial Analyst 

António Ramos, CEFA

Share This: