Economics
Interest Rate Risk
Interest rate risk refers to the potential for changes in interest rates to negatively impact the value of an investment or asset. It affects both fixed-income securities and loans, as fluctuations in interest rates can lead to changes in the value of these financial instruments. Investors and financial institutions must manage interest rate risk to mitigate potential losses.
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9 Key excerpts on "Interest Rate Risk"
- Jana Schönborn(Author)
- 2010(Publication Date)
- Diplomica Verlag(Publisher)
13 4. Quantifying Interest Rate Risk 4.1. Understanding Interest Rate Risk In order to understand Interest Rate Risks, it is vital to analyse the factors that affect interest rates. Interest rates are made up of the real rate plus the expected rate of inflation and a risk premium. Investors demand at least the inflation rate, since the purchasing power of an asset is reduced by it. The risk premium indicates the creditworthiness of a borrower, but it may also rise due to a general increase in the risk for instance during periods of a financial market crisis. Moreover the level of market interest rates is influenced by other general economic conditions, as for instance the foreign investor demand for debt securities, the monetary policy as well as the financial and political stability. 47 There are three main types of interest risk: Absolute Interest Rate Risk, arising from changes in the level of interest rates. Yield curve risk, arising from changes in the shape of the yield curve. When the level of interest rates changes, the yield curve rarely shifts in a parallel manner, it can even show twists or humps. Basis risk, arising from mismatches between exposure and risk management instrument. The yield curve represents all spot rates respective their terms to maturity, and forms the basis for the evaluation of all interest-bearing positions. There are usually several yield curves 48 within a currency area, which can move independently from each other. Since investors demand a higher return for longer lending terms, long-term rates are normally higher than short-term rates. The resulting yield curve is upward sloping and also referred to as a normal, concave yield curve. In contrast an inverse yield curve is characterised by higher spot rates at the short-end than the rates at the long-end. Temporarily the short-term interest rates may be higher than the rates for longer terms caused by a rise in demand for short-term funds.
eBook - PDF- Paul Sweeting(Author)
- 2011(Publication Date)
- Cambridge University Press(Publisher)
93 94 Definitions of risk Market risk for non-life insurance companies again relates to the portfolios of marketable assets held, but is also closely related to assumptions used for claims inflation. Similarly, for life insurance companies and pension schemes, the market risk in the asset portfolios is linked to the various economic assump- tions used to value the liabilities, in particular the rate at which those liabilities are discounted. For these two types of institution, market risk is arguably the most significant risk faced. 7.3 Interest Rate Risk Interest Rate Risk is a type of market risk that merits particular consideration. It is the risk arising from unanticipated changes in interest rates of various terms. This can be changes in the overall level of interest rates, or in the shape of the yield curve – that is, in interest rates at different terms by different amounts. As mentioned above, it affects both the value of long-term financial liabili- ties and the value of fixed interest investments. It is also interesting because expected returns at different points in the future are closely linked through the term structure of interest rates. This means that modelling interest rates brings particular considerations that have resulted in a number of models designed to deal with the issues arising from this term structure. The term structure of interest rates is an important aspect of Interest Rate Risk. In particular, holding interest-bearing assets to hedge interest sensitive liabilities is only effective if both are affected by various changes in interest rates in a similar way. 7.4 Foreign exchange risk Foreign exchange risk is another special type of market risk or economic risk. It reflects the risk present when cash flows received are in a currency different from the cash flows due. Foreign exchange risk is sometimes cited as a component of equity market risk when comparing domestic and overseas equities.
eBook - PDF- Aparna Gupta(Author)
- 2016(Publication Date)
- CRC Press(Publisher)
8.8 Questions and Exercises Review Questions 1. What is Interest Rate Risk? Discuss its most important characteristics. 2. Who are the major participants in the fixed income markets? Discuss the purpose of their participation. 3. What are curve risk, basis risk, and gap risk in the context of Interest Rate Risk? 4. Given the term structure of interest rates, in the simple setting how are bonds priced? What is the yield to maturity of a bond? 5. What are the different possible shapes of the term structure of interest rates? What are the implications of a changing term structure of interest rates? 6. What are continuously compounding interest rates? How are they use-ful? Managing Interest Rates and Other Market Risks 319 7. What are forward rates? How are they computed? How are forward rates used? 8. What is short rate? What theories are stochastic short rate models con-structed by? 9. Give examples of equilibrium and no-arbitrage short rate models. 10. What is market price of risk? How is it arrived at, and what does it achieve in the pricing of bonds? 11. What are the multi-factor extensions of single-factor short rate models? Why are these extensions needed? 12. Discuss the types of fixed income instruments, by issuers, maturities, and other terms of the instruments. 13. How are interest rate sensitivities measured? What are duration, modi-fied duration and convexity measures of sensitivity? 14. When are modified duration and convexity measures of Interest Rate Risk not sufficient for risk measurement and management? 15. What are the three factors that capture well the movements of the term structure of interest rates? 16. How can dynamics of term structure of interest rates be captured through movements of key factors? 17. What is bond immunization? What risk measures is the immunization achieved by? 18. What are exchange-traded interest rate derivatives? What are the over-the-counter interest rate derivatives? 19.
eBook - PDF- Paul Sweeting(Author)
- 2017(Publication Date)
- Cambridge University Press(Publisher)
As mentioned above, it affects both the value of long-term financial liabilities and the value of fixed interest investments. It is also interesting because expected returns at different points in the future are closely linked through the term structure of interest rates. This means that modelling interest rates brings particular considerations that have resulted in a number of models designed to deal with the issues arising from this term structure. The term structure of interest rates is an important aspect of Interest Rate Risk. In particular, holding interest-bearing assets to hedge interest sensitive liabilities is only effective if both are affected by various changes in interest rates in a similar way. 7.4 Foreign Exchange Risk Foreign exchange risk is another special type of market risk or economic risk. It reflects the risk present when cash flows received are in a currency different from the cash flows due. Foreign exchange risk is sometimes cited as a component of equity market risk when comparing domestic and overseas equities. However, the underlying cash flows of many domestic equities are from unhedged overseas sources, and in many cases a stock listed on an exchange in one country will have a similar pattern of underlying cash flows to one listed elsewhere. This is particularly true for multi- national firms whose main differences are the locations of their head offices. This 7.5 Credit Risk 105 suggests that unless there are regular, significant arbitrage opportunities, the prices of such stocks should follow each other rather than the currencies of the exchanges on which they are listed. 7.5 Credit Risk Credit risk can be defined in a number of ways. In some cases, it will refer only to default risk. In other words, it is limited to the risk of loss from non-payment. Under this definition, the other main aspect of credit risk – that is, spread risk or the risk of a change in value due to a change in the spread – is covered by market risk.
eBook - PDFFundamentals of Finance
Investments, Corporate Finance, and Financial Institutions
- Mustafa Akan, Arman Teksin Tevfik(Authors)
- 2020(Publication Date)
- De Gruyter(Publisher)
A simple exam-ple will suffice to explain that risk. Suppose a financial institution buys a long-term bond after valuing it by dis-counting the related cash inflows from the bond at a certain interest rate (discount rate). However, if the discount rate changes due to an external reason, the value of the bond will decline, causing a loss. 5 For further information, see David J. Moore, Dr Moores ’ Perspectives in Finance: Financial Institutions , CreateSpace, 2010, pp. 155 – 161. 342 16 Risk Management in Financial Institutions As interest rate volatility has increased in the last 30 years, interest-rate risk exposure has become a concern for financial institutions. To see how financial institutions can measure and manage interest-rate expo-sure, we will examine the balance sheet for DEF Bank. We will develop two tools: income gap analysis and duration gap analysis 6 to assist the financial manager in this effort. Income Gap Analysis Income gap analysis measures the sensitivity of a bank ’ s current year net income to changes in interest rate. It requires determining which assets and liabilities will have their interest rates change as market interest rates change. Let ’ s see how that works for DEF Bank (see Tables 16.1 and 16.2).
eBook - ePubBanking and Financial Markets
How Banks and Financial Technology Are Reshaping Financial Markets
- Andrada Bilan, Hans Degryse, Kuchulain O’Flynn, Steven Ongena, Kuchulain O'Flynn(Authors)
- 2019(Publication Date)
- Palgrave Macmillan(Publisher)
Further, there is heterogeneity in banks’ exposure to Interest Rate Risk with some banks benefiting from an increase in interest rates, which creates a redistributive effect of monetary policy within the banking industry (Hoffmann et al. 2018). The literature further shows that banks do indeed use interest rate derivatives to manage their on-balance sheet exposure and that the extent to which they hedge depends on bank characteristics and derivative market conditions (Purnanandam 2007 ; Esposito et al. 2015 ; Hoffmann et al. 2018). Finally, the literature finds that a bank’s decision to manage and method of managing Interest Rate Risk affects the transmission of monetary policy (Purnanandam 2007 ; Gomez et al. 2016 ; Hoffmann et al. 2018), the value of its equity (Flannery and James 1984b ; English et al. 2018), its lending behaviour, and, hence, the investment and employment decisions of the firms to which they lend (Gomez et al. 2016). The remainder of this chapter is organized as follows: we begin by reviewing the data sources and methodologies employed in the Interest Rate Risk in banking literature. We continue by discussing the literature that seeks to uncover the following: (1) If and why banks are exposed to Interest Rate Risk. (2) How and why banks manage Interest Rate Risk. (3) What the consequences are of banks’ decision to manage Interest Rate Risk for the transmission of monetary policy and for the firms to which they lend. 3.1 Data To conduct an analysis on bank’s Interest Rate Risk exposure, researchers need to estimate the degree to which banks are affected by changes in the interest rate. To do this, researchers need detailed information on the maturity of banks’ assets and liabilities. A common measure for banks’ on-balance sheet interest rate exposure is the income gap, that is, the difference between the bank’s assets that mature (or reprice) within a year and its liabilities that mature (or reprice) within a year
eBook - PDF- Scott Besley, Eugene Brigham, Scott Besley(Authors)
- 2021(Publication Date)
- Cengage Learning EMEA(Publisher)
Inflation risk The primary reason interest rates change in the short term is because investors change their expectations about future inflation. Maturity risk Long-term investments experience greater price reactions to interest rate changes than do short-term investments. Liquidity risk Reflects the fact that some investments are more easily converted into cash on a short notice at a “reasonable price” than are other securities. Exchange rate risk Multinational firms deal with different currencies; the rate at which the currency of one country can be exchanged into the currency of another country—that is, the exchange rate—changes as market conditions change. Political risk Any action by a government that changes the value of an investment. II. Unsystematic risks (diversifiable risk; firm-specific risk) Business risk Risk that would be inherent in the firm’s operations if it used no debt—factors such as labor conditions, product safety, quality of management, competitive conditions, and so forth, affect firm-specific risk. Financial risk Risk associated with how the firm is financed; that is, its credit risk. Default risk Part of financial risk, the chance that the firm will not be able to service its existing debt. III. Combined risks (some systematic risk and some unsystematic risk) Total risk (Stand-alone risk) The combination of systematic risk and unsystematic risk; also referred to as stand- alone risk, because this is the risk an investor takes if he or she purchases (holds) only one investment, which is tantamount to “putting all your eggs into one basket.” Corporate risk The riskiness of the firm without considering the effect of stockholder diversification; based on the combination of assets held by the firm (inventories, accounts receivable, plant and equipment, and so forth). Some diversification exists because the firm’s assets represent a portfolio of investments in real assets.
eBook - PDFForeign Exchange in Practice
The New Environment
- S. Anthony(Author)
- 2002(Publication Date)
- Palgrave Macmillan(Publisher)
CHAPTER 14 Value at Risk In mathematics, risk exists whenever there is uncertainty. A change in the value of one variable can lead to an increase or decrease in the value of a second variable. In finance risk is taken to be the risk that the monetary value of an asset will fall as a result of a change in some factor. The risk that the monetary value of the asset will increase is considered opportunity. In the real world uncertainty exists all of the time. Financial risk and opportunity are always present. In this chapter the three major categories of financial risk are examined – market price risk, credit risk and liquidity risk. These three categories of risk are separate but interdependent. Tech- niques to measure the value at risk and to manage each of these types of risk are discussed. MARKET PRICE RISK Market price risk is the risk that an asset or portfolio of assets will lose value as a result of a change in the price of a market factor. A rise in interest rates will reduce the value of a bond. A change in exchange rates may cause a foreign exchange position to result in a loss. An increase in volatility will tend to reduce the value of a short option strategy, and so on. Interest rates, exchange rates, volatility and time are referred to as market factors. Other examples of market factors include equity and commodity prices and spreads or the correlation between different factors. FACTOR SENSITIVITIES Factor sensitivities measure the extent to which a specific change in a market factor would result in a gain or loss. 291 EXAMPLE 14.1 A US dollar-based company has a net short exchange position of £10,000,000 against US dollars. A 1% increase in the £/US$ rate from 1.5000 to 1.5150 would lead to a loss of US$150,000.
eBook - PDF- Y. Stander(Author)
- 2005(Publication Date)
- Palgrave Macmillan(Publisher)
When any yield curve model is created, there are some risks that have to be measured, managed and possibly be prevented. In Section 8.1 Interest Rate Risk management is discussed. It is important to understand what types of Interest Rate Risks there are and how to measure them, because this helps to identify potential problems in a yield curve model. Sections 8.2 and 8.3 covers operational risk and model risk respectively. Some examples are discussed showing where these risks may occur with respect to yield curves. In practice model risk is considered to be a subsection of operational risk. Liquidity risk is discussed in Section 8.4. Some examples show how to get a feel for the liquidity of the various instruments that are considered when deriving a yield curve. 8.1 Interest Rate Risk 8.1.1 Definition When we have a portfolio with interest rate instruments, there are usually three types of risks for which allowance has to be made: parallel risk, pivot risk, and basis risk. Parallel risk refers to the loss that a portfolio can incur when the whole curve moves up or down by a certain number of basis points. With pivot risk we make allowance for the fact that different parts of the yield curve may move in different directions, for instance the short-term rates may move down and the long-term rates may move up from one day to the next. Finally we have to consider the situation when a traded security and its hedge are valued from two different curves. With basis risk we allow for the fact that these two curves may not necessarily move together. This Risk Issues 156 CHAPTER 8 means the hedge may not always be effective, which then increases the risk of the portfolio. 8.1.2 Measuring parallel and pivot risk There are various ways in which to measure parallel risk. A primitive way is to stress the whole yield curve up and down, using a stress factor, to determine the effect on the portfolio.
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