Final answer:
Interest rate risk is the potential for the value of fixed-rate investments, like bonds, to decline when interest rates rise, or to increase when interest rates fall. The expected rate of return is an average projection of profitability, while the actual rate of return is the total return realized at the end of a period, including capital gains and interest earned.
Step-by-step explanation:
Interest rate risk is the possibility that changes in interest rates may negatively impact the value of an investment. This risk is particularly relevant for fixed-rate investments like bonds. For instance, when interest rates rise, the value of existing bonds with lower interest rates generally declines, because new bonds may be issued with higher rates, making the older ones less attractive. Conversely, when interest rates fall, the value of these bonds tends to increase, as they pay a comparatively higher rate than new bonds.
An investment's expected rate of return is an average projection of its profitability, considering future interest payments, capital gains, or increased profitability. Investments come with different levels of risk, such as default risk and interest rate risk. A high-risk investment tends to have a broader range of potential outcomes, with actual returns fluctuating significantly from the expected rate of return. In contrast, a low-risk investment typically has actual returns that more closely align with its expected rate of return over time.
Actual rate of return represents the total rate of return on an investment after accounting for capital gains and interest earned during a specific period. All investments, including bank accounts, are subject to various risks, one of which is the interest rate risk associated with fluctuating market interest rates.