Economics
Interest Rate Risk Management
Interest rate risk management involves strategies and techniques used by financial institutions and investors to mitigate the potential negative impact of interest rate fluctuations on their investments and financial positions. This can include using derivatives, diversifying investment portfolios, and implementing hedging strategies to protect against adverse interest rate movements. Effective interest rate risk management is crucial for maintaining financial stability and minimizing potential losses.
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eBook - PDFAnalytical Finance: Volume II
The Mathematics of Interest Rate Derivatives, Markets, Risk and Valuation
- Jan R. M. Röman(Author)
- 2017(Publication Date)
- Palgrave Macmillan(Publisher)
9 Risk Management 9.1 Introduction to Risk Management We will now give a short introduction of how to measure risk and how to define limits on risks for a portfolio with many different instruments. Such limits are used by financial institutions to control and minim- ize risks. There have been more and more focus on risk management, especially after the financial crises in 2007–2008. Financial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk, particularly Counterparty Credit risk and Market risk. Here we will focus on market risk. Market risks includes: • Equity risk, the risk that stock or stock indices prices and/or their implied volatility will change. • Interest rate risk, the risk that interest rates and/or their implied volatility will change. • Currency risk, the risk that foreign exchange rates and/or their implied volatility will change. • Commodity risk, the risk that commodity prices and/or their implied volatility will change. Some other sources of risk have been discussed in other sections of these lecture notes. Such risks include foreign exchange risk, liquid- ity risk, inflation risk, model risk, settlement risk, correlation risk, operational risk etc. In order to ensure the survival of the financial firm and to comply with the provisions of the regulators, firms must have methods in place © The Author(s) 2017 261 J.R.M. Röman, Analytical Finance: Volume II, https://doi.org/10.1007/978-3-319-52584-6_9 262 J.R.M. Röman to regularly measure and maintain sufficient Capital to cover the nature and level of the risks to which the firm is or may be exposed to. The firm has both an obligation and an opportunity to design appropriate risk management systems that are tailored to their unique business requirements. Financial risk management can be both qualitative and quantitative.
eBook - PDF- Aparna Gupta(Author)
- 2016(Publication Date)
- CRC Press(Publisher)
Chapter 8 Managing Interest Rates and Other Market Risks In an introductory finance course, the first concept explained is that of Time Value of Money . This is an important and fundamental concept at the core of all monetary transactions with a temporal element, and the core mechanism by which monetary resources move in an economy to be allocated for their most beneficial use. The entity extending credit by parting with some idle monetary resources expects to get them back, but expects to be rewarded for the act of parting with its resources. One can consider this reward to be the op-portunity cost of the entity extending the credit using its monetary resources. This opportunity cost constitutes the interest rates involved in borrowing and lending in an economy. This is a simple description for interest rates, albeit giving an impression that an interest rate is a static, universally applied quantity to assess the time value of money. That is, in fact, how it is dealt with in an introductory exposition, and the way we will begin here. However, in the real world there are a multitude of interest rates used depending on the nature of entities at the two ends of contracts, borrower’s financial health, duration of borrowing and lending, collateral used, economic conditions, and the monetary policy, to name a few. Changing market and economic conditions also put pressures on interest rates to move, change, and fluctuate. This is the risk we study in this chapter, along with its impact and management. Entities that concern themselves with interest rates and the underlying risks range from individuals, governments, corporations, investment institu-tions, banks, and insurance firms. Therefore, interest base for interest rates is broad. Interest rate risk is closely related with two other risks -credit risk and liquidity risk -both of which we will study in later chapters.
- Michael Brandl(Author)
- 2020(Publication Date)
- Cengage Learning EMEA(Publisher)
For decades after World War II, com-mercial banks in the United States did not have to worry much about interest rate risk. During this time period, the Federal Reserve used its monetary policy tools to keep overall interest rates low and stable. To discourage competition, the banking system was heavily regulated with things such as Regulation Q that kept interest rates on deposits low and stable. Thus, interest rates did not change much, and banks did not face much interest rate risk. Interest rate risk: The chance that the value of an asset will change because of a change in interest rates. Over the past few decades, however, with the Federal Reserve changing how it conducts monetary policy and allowing interest rates to fluctuate much more, combined with banking deregulation that has caused banks to face more and more competition for both deposit and loan business, times have changed dramatically. Now banks have to worry a great deal about interest rate risk. As interest rates change, both interest expense (how much banks have to pay for funds) and interest income (how much banks earn on their assets such as loans that pay interest) can change significantly. 13-2a Interest Rate Risk in General Thus, banks need to “manage” their interest rate risk. The first step in managing risk is under-standing why the risk exists and then figuring out just how much exposure a bank has. Keep in mind that changes in interest rates affect both sides of a bank’s balance sheet. When interest rates change, bank assets such as consumer loans, business loans, bonds the bank holds, federal funds sold, and other investments are affected. Similarly, changes in interest rates affect bank liabilities, such as the interest the bank must pay on demand deposits, savings accounts, and newly issued certificates of deposits (CDs). Remember also that bank deposits tend to be short-term, whereas loans tend to be long-term.
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- Kent Matthews, John Thompson(Authors)
- 2014(Publication Date)
- Wiley(Publisher)
CHAPTER 14 Risk Management MINI-CONTENTS 14.1 INTRODUCTION 14.2 RISK TYPOLOGY 14.3 Interest Rate Risk Management 14.4 MARKET RISK 14.5 CREDIT RISK 14.6 OPERATIONAL RISK 14.7 RISK MANAGEMENT AND THE GLOBAL BANKING CRISIS 14.8 CONCLUSION 14.9 SUMMARY 14.1 INTRODUCTION The business of banking involves risk. Banks make profit by taking risk and managing risk. The traditional focus of risk management in banks has typically arisen out of their main business of intermediation – the process of making loans and taking in deposits. These are risks relating to the management of the balance sheet of the bank and are identifiable as credit risk, liquidity risk and interest rate risk. In Chapters 4 and 5 we have already examined bank strategies for dealing with credit risk and liquidity risk. This chapter will concentrate on understanding the problems of measuring and coping with interest rate risk and further elaboration of the problems of credit risk management. After reviewing the standard tools of risk management used by financial institutions, the chapter ends with an examination of the question: Was it weak risk management or weak risk managers that failed to sound the alarm for the coming financial crisis? The advance of off-balance-sheet activity of the bank (see Table 1.7 for the growth of non- interest income) has given rise to other types of risk relating to its trading and income-generating activity. Banks have increasingly become involved in the trading of securities, derivatives and currencies. These activities give rise to position or market risk. This is the risk caused by a change in the market price of the security or derivative in which the bank has taken a position. While it is not always sensible to isolate risks into separate compartments, risk management in banking has been concerned with the risks on the banking book as well as the trading book. This chapter provides an overview of risk management by banks.
eBook - PDFFundamentals of Finance
Investments, Corporate Finance, and Financial Institutions
- Mustafa Akan, Arman Teksin Tevfik(Authors)
- 2020(Publication Date)
- De Gruyter(Publisher)
16 Risk Management in Financial Institutions 16.1 Introduction Risk is the probability that the outcome of an event will result in the reduction of wealth. It implies a loss of wealth or income. Any firm is subjected to different types of risks, which will diminish the value of the firm. Any environment in which a firm is in constant change may have negative influences on entities in that environment. In this chapter, we will review basic risks such as credit risk, liquidity risk, interest rate risk, market risk, off-balance-sheet risks, foreign exchange, country risk, technological risk, operational risks, insolvency risks, and derivatives such as options, futures, and swaps to manage most of the risks that financial institutions face. 16.2 The Risks Most financial firms are intermediaries. They channel the funds of the savers to the borrowers and investors and hence they provide an essential service for the proper functioning of the economy. They need to continue to make a reasonable income for their stockholders and they also need to be able to pay their depositors or lend-ers when required. They borrow from millions of savers, they lend to millions of customers (including other financial institutions), and they perform other financial services to both individuals and corporations. They face many changes. There may be internal changes, such as management changes, infrastructural changes, and changes in the ownership structure. There may be changes in the sector such as many new entrants. There may be changes in basic economic variables such as the exchange rates, interest rates, unemployment rate, and inflation rate. There may be changes in the legal structure concerning the sector. Lastly, there may be changes in the world economy. The financial institutions (FIs) will be affected by degrees by all of these changes which may negatively affect the entities. The risks associated with all of these changes are classified as: 1 – Credit risk .
eBook - PDF- Hans Keiding(Author)
- 2017(Publication Date)
- Red Globe Press(Publisher)
Risk management is an important part of what a bank does, but it is also an aspect of banking which is closely interrelated with the control and regulation of banks. It matters for society that banks are managed in a proper way, in particular that they do not run excessive risks, and with the Basel regulations from 1988 onwards – about which we shall have much to say as we proceed – this has resulted in a considerable expansion of the e ff orts in measuring and managing risk. 41 42 Chapter 3: Basic concepts of risk management 3.1.1 Types of risk in banking Just as banking consists of several di ff erent business activities, there are several main types of risk occuring in financial intermediation. Some of these are connected with the specific business lines; others are common to all of them. Liquidity risk . This is the risk that the financial institution will not be able to meet its obligations at a designated point of time, although it has the necessary assets. Liquidity risk typically arises as withdrawal risk. Depositors may claim back their assets at short notice, often for reasons which are not connected with the way in which the bank is man-aged, and if the number of withdrawals is large enough, it takes the form of a run on the bank. We have already considered the role of a financial institution in transforming liquidity; taking on highly liquid obligations and covering the obligations by illiquid assets is a central feature of banking, so liquidity risk cannot be avoided, but it is fundamental for the functioning of the bank that it can foresee and control its liquidity. The liquidity of a given asset has to do with whether there are well-functioning markets for this specific type of asset. If such markets exist, the asset can be disposed of at market prices, and no liquidity problem arises; of course, the bank may lose money due to the development of market prices, but this is another problem (and the associated risk is of another type).
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.
- Jana Schönborn(Author)
- 2010(Publication Date)
- Diplomica Verlag(Publisher)
The basic assumptions of the scenario should be agreed by the management. 117 Since there are typically tight personnel constraints in the treasury department and interest risk management in a service enterprise has not as a high status as for instance in a bank, where it is also governed by even more regulations, an effective risk management has to be attempted. The mapping of cash flows is an instrument to simplify the cash flow and thereby reduce the effort to manage the risk. When it comes to the method of cash flow mapping it is a question how much effort the company wants to put into their interest risk management. The variance mapping is the most complicated of the three methods being discussed, but also the most precise one. When deciding between the duration mapping and the convexity mapping, one has to consider that the duration mapping has a significant higher estimation error since it ignores the convexity of the present value changes. On the other hand the increase in the complexity that comes with the convexity mapping can be nearly overruled with today’s standard in technology. 118 116 Rau-Bedrow, 2001 117 Rau-Bedrow, 2001 118 See section 4.4.2 and 4.4.3. 33 5. Interest Risk Management Techniques 5.1. Hedging 5.1.1. Introduction to Hedging After having discussed how to quantify interest rate risk, this section examines the possibilities for reducing the risk with the help of interest rate hedging instruments. Interest rate derivatives are interest instruments deriving its value from an underlying instrument (e.g. LIBOR, EURIBOR). Derivatives entitle the buyer to purchase or sale an underlying instrument at an agreed price on a future date. 119 They are either traded over future exchanges or directly between financial institutions and enterprises (= over-the-Counter). Exchange traded instruments generally possess a higher liquidity, a stronger standardisation and a permanent price fixing by the clearing-house.
eBook - ePubInterest Rate Risk in the Banking Book
A Best Practice Guide to Management and Hedging
- Beata Lubinska(Author)
- 2021(Publication Date)
- Wiley(Publisher)
Chapter 5 Interest rate risk and asset liability management MANAGEMENT OF IRRBB UNDER STRATEGIC ALM – PROACTIVE MANAGEMENT OF IRRBB This section is the most crucial in this book. It focuses on the proactive management of interest rate risk which means optimisation of hedging strategy achieved through the multi‐dimensional exercise, and the integrated management of different aspects – such as the liquidity profile of a bank, its IRRBB exposure, position on the interest rate curve, diversification of funding sources and avoidance of maturity cliffs – provides the quantifiable savings in terms of funding cost. This book proposes the adoption of a proactive approach for the funding plan strategy setting. The proportions of funding sources are precisely calibrated in order to reduce hedging expenses (and costs of hedge accounting designation) and, at the same time, to reduce the cost of funding. The funding tenor and proportions are driven by growth on the asset side and its financial characteristics. It means that funding strategy is not a silo basis exercise. It is a proactive and sophisticated process which brings both aspects together, i.e., hedging based on the projected growth on the asset side and reduction in the overall funding cost. Additionally, there is a description of both directional gap strategy on the short end of the interest rate curve (usually up to 12 months), natural hedging strategy and residual gap hedging strategy on the medium‐to‐long part of the curve. The second part of this section is dedicated to the strategic Funds Transfer Pricing (strategic FTP) which works as a tool to achieve the target profile of the bank. The words “strategic” and “optimised” are heard even more frequently in the aftermath of the financial crisis, the introduction of negative rates and onerous regulatory landscape
eBook - PDFAsset Liability Management Optimisation
A Practitioner's Guide to Balance Sheet Management and Remodelling
- Beata Lubinska(Author)
- 2020(Publication Date)
- Wiley(Publisher)
However, static methods have evolved over time and have been enriched through the introduc-tion of the advanced deviations of the basic methodologies proposed by the regulator. This methodological progress aims to provide the bank with the clear picture of the underlying forms of IRRBB. Before entering into details of the methods for measuring IRRBB, it is necessary to introduce briefly the subtypes of this risk category and define it properly. Interest rate risk in the banking book (IRRBB) refers to the current or prospective risk to the bank’s net economic value (EV), capital, and earnings arising from adverse movements in interest rates that affect the bank’s banking book positions. The exposure 28 ASSET LIABILITY MANAGEMENT OPTIMISATION to the interest rate risk derives both from the variation of the interest rate to which the transaction is linked at the fixing date and consequently having an impact on the interest flow and the interest margin, and from the positions in maturity which are going to be reinvested or refinanced at the new rate. The first type of risk exists only in the case of floating rate transactions and only for the component in refixing (as opposed to the component in maturity). The second one refers to transactions at fixed rate. There are the following subtypes of IRRBB: ■ Gap risk, which arises from the term structure of banking book instruments, and describes the risk arising from the timing of instrument rate changes. The risk to the bank arises when the rate of interest paid on liabilities increases before the rate of interest received on assets or reduces on assets before liabilities. The extent of gap risk depends on whether changes to term structure of interest rates occur consistently across the whole yield curve (parallel risk) or differently by period (non-parallel risk). Banks measure and control the gap risk through the repric-ing gap and analysis of the net mismatch for every time band and by material currency.
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