Interest rate risk is a form of market risk. Interest rate risk states that the relational or proportional value of an interest rate security, for example, a bond or loan, will decline because of a hike in interest rate. Commonly, if the interest rates go up, the price or value of a bond carrying fixed rates of interest will go down and it happens the other way around.
The measurement of interest rate risk is generally performed with the help of the duration or term of the bond and this is the earliest among the numerous methods that are being implemented for handling interest rate risk. One of the most basic techniques applied for management of interest rate risk is asset liability management. This technique involves a comprehensive collection of methods that are utilized in a common organizational risk management infrastructure.
Calculation of Interest Rate Risk
The analysis of interest rate risk is mostly done on the basis of simulating changes in a number of yield curves applying the Heath-Jarrow-Morton framework for assuring that the yield curve shifts are uniform with present market yield curves so that there is no possibility of a risk free arbitrage. In the earlier part of 1990s, the Heath-Jarrow-Morton framework was formulated by Andrew Morton of the Lehman Brothers, David Heath of Cornell University and Robert A. Jarrow of Cornell University and Kamakura Corporation.
There are numerous standardized computation methods used for the measurement of the influence of varying rates of interest in a portfolio, which is made up of different types of assets and liabilities.
The most fundamental methods are the following:
1) Grading to market and computation of the net market value of the liabilities and assets. In some instances, it is termed as market value of portfolio equity.
2) Performing a stress test of that market value with the help of a shift on the yield curve in a particular manner. Duration is a form of stress testing in which case the shift of the yield curve is parallel in nature.
3) Computation of the Value at Risk on the portfolio.
4) Computation of the accumulated financial income and expenditure or cash flows for multiple periods for N durations in advance in a settled collection of future yield curves.
5) The fifth step involves performing step 4 with the help of yield curve shifts that are stochastic in nature and the measurement of cash flow probability distributions and accumulated financial earnings over the passage of time.
6) Measurement of the disparity of the asset and liability interest sensitivity gap with the help of categorizing every type of asset and liability through the timing of maturity or rate of interest readjustment, whichever occurs earlier.
Interest Rate Risk and Banks
There are four types of interest rate risk that are faced by the banks and they are the following:
Yield curve risk: This is expressed when there are deviations or variations between long-term and short-term rates of interest.
Basis risk: This risk is expressed when returns from assets and expenses on liabilities are established on distinct bases, for example, the US prime rate versus the LIBOR or London Interbank Offered Rate.
Option risk: This risk is exhibited with the help of optionality, which is imbedded in a number of assets and liabilities
Repricing risk: This risk is demonstrated by the liabilities and assets, repricing of which is done at various rates and times.
Hedging of interest rate risk may be performed with the help of interest rate swaps or financial instruments carrying fixed rate of income. Interest rate risk may be minimized through purchasing bonds with short term periods or taking part in a fixed for floating interest rate swap.
Last Updated on : 1st July 2013