Interest rate risk
Encyclopedia
Interest rate risk is the risk (variability in value) borne by an interest-bearing asset, such as a loan or a bond
, due to variability of interest rate
s. In general, as rates rise, the price of a fixed rate bond
will fall, and vice versa. Interest rate risk is commonly measured by the bond's duration
.
Asset liability management
is a common name for the complete set of techniques used to manage risk within a general enterprise risk management
framework.
s using the Heath-Jarrow-Morton framework
to ensure that the yield curve movements are both consistent with current market yield curves and such that no riskless arbitrage is possible. The Heath-Jarrow-Morton framework was developed in the early 1990s by David Heath of Cornell University, Andrew Morton of Lehman Brothers, and Robert A. Jarrow
of Kamakura Corporation and Cornell University.
There are a number of standard calculations for measuring the impact of changing interest rates on a portfolio consisting of various assets and liabilities. The most common techniques include:
Basis risk: the risk presented when yields on assets and costs on liabilities are based on different bases, such as the London Interbank Offered Rate
(LIBOR) versus the U.S. prime rate. In some circumstances different bases will move at different rates or in different directions, which can cause erratic changes in revenues and expenses.
Yield curve risk: the risk presented by differences between short-term and long-term interest rates. Short-term rates are normally lower than long-term rates, and banks earn profits by borrowing short-term money (at lower rates) and investing in long-term assets (at higher rates). But the relationship between short-term and long-term rates can shift quickly and dramatically, which can cause erratic changes in revenues and expenses.
Repricing risk: the risk presented by assets and liabilities that reprice at different times and rates. For instance, a loan with a variable rate will generate more interest income when rates rise and less interest income when rates fall. If the loan is funded with fixed rated deposits, the bank's interest margin will fluctuate.
Option risk: the risk presented by optionalities embedded in some assets and liabilities. For instance, mortgage loans present significant option risk due to prepayment speeds that change dramatically when interest rates rise and fall. Falling interest rates will cause many borrowers to refinance and repay their loans, leaving the bank with uninvested cash when interest rates have declined. Alternately, rising interest rates cause mortgage borrowers to repay slower, leaving the bank with more loans based on prior, lower interest rates. Option risk is difficult to measure and control.
Model risk: the risk presented by mathematical models used to price asset and liabilities not directly quoted on the market. Interest rate pricing models are based on reasonable assumptions about the behaviour of interest rates that may fail in particular market conditions.
Most banks are asset sensitive, meaning interest rate changes impact asset yields more than they impact liability costs. This is because substantial amounts of bank funding are not affected, or are just minimally affected, by changes in interest rates. The average checking account pays no interest, or very little interest, so changes in interest rates do not produce notable changes in interest expense. However, banks have large concentrations of short-term and/or variable rate loans, so changes in interest rates significantly impact interest income. In general, banks earn more money when interest rates are high, and they earn less money when interest rates are low. This relationship often breaks down in very large banks that rely significantly on funding sources other than traditional bank deposits. Large banks are often liability sensitive because they depend on large concentrations of funding that are highly interest rate sensitive. Large banks also tend to maintain large concentrations of fixed rate loans, which further increases liability sensitivity. Therefore, large banks will often earn more net interest income when interest rates are low.
, fixed income
instruments or fixed-for-floating interest rate swaps.
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
, due to variability of interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
s. In general, as rates rise, the price of a fixed rate bond
Fixed rate bond
In finance, a fixed rate bond is a type of debt instrument bond with a fixed coupon rate, as opposed to a floating rate note. A fixed rate bond is a long term debt paper that carries a predetermined interest rate...
will fall, and vice versa. Interest rate risk is commonly measured by the bond's duration
Bond duration
In finance, the duration of a financial asset that consists of fixed cash flows, for example a bond, is the weighted average of the times until those fixed cash flows are received....
.
Asset liability management
Asset liability management
In banking, asset and liability management is the practice of managing risks that arise due to mismatches between the assets and liabilities of the bank. This can also be seen in insurance....
is a common name for the complete set of techniques used to manage risk within a general enterprise risk management
Risk management
Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...
framework.
Calculating interest rate risk
Interest rate risk analysis is almost always based on simulating movements in one or more yield curveYield curve
In finance, the yield curve is the relation between the interest rate and the time to maturity, known as the "term", of the debt for a given borrower in a given currency. For example, the U.S. dollar interest rates paid on U.S...
s using the Heath-Jarrow-Morton framework
Heath-Jarrow-Morton framework
The Heath–Jarrow–Morton framework is a general framework to model the evolution of interest rate curve – instantaneous forward rate curve in particular . When the volatility and drift of the instantaneous forward rate are assumed to be deterministic, this is known as the Gaussian...
to ensure that the yield curve movements are both consistent with current market yield curves and such that no riskless arbitrage is possible. The Heath-Jarrow-Morton framework was developed in the early 1990s by David Heath of Cornell University, Andrew Morton of Lehman Brothers, and Robert A. Jarrow
Robert A. Jarrow
Robert Alan Jarrow is the Ronald P. and Susan E. Lynch Professor of Investment Management at the Johnson Graduate School of Management, Cornell University...
of Kamakura Corporation and Cornell University.
There are a number of standard calculations for measuring the impact of changing interest rates on a portfolio consisting of various assets and liabilities. The most common techniques include:
- Marking to market, calculating the net market value of the assets and liabilities, sometimes called the "market value of portfolio equity"
- Stress testing this market value by shifting the yield curve in a specific way. DurationBond durationIn finance, the duration of a financial asset that consists of fixed cash flows, for example a bond, is the weighted average of the times until those fixed cash flows are received....
is a stress test where the yield curve shift is parallel - Calculating the Value at RiskValue at riskIn financial mathematics and financial risk management, Value at Risk is a widely used risk measure of the risk of loss on a specific portfolio of financial assets...
of the portfolio - Calculating the multiperiod cash flow or financial accrual income and expense for N periods forward in a deterministic set of future yield curves
- Doing step 4 with random yield curve movements and measuring the probability distribution of cash flows and financial accrual income over time.
- Measuring the mismatch of the interest sensitivity gapInterest sensitivity gapThe interest sensitivity gap was one of the first techniques used in asset liability management to manage interest rate risk. The use of this technique was initiated in the middle 1970s in the United States when rising interest rates in 1975-1976 and again from 1979 onward triggered a banking...
of assets and liabilities, by classifying each asset and liability by the timing of interest rate reset or maturity, whichever comes first.
Banks and interest rate risk
Banks face many types of interest rate risk:Basis risk: the risk presented when yields on assets and costs on liabilities are based on different bases, such as the London Interbank Offered Rate
London Interbank Offered Rate
The LIBOR rate is the average interest rate that leading banks in London charge when lending to other banks. It is an acronym for London Interbank Offered Rate Banks borrow money for one day, one month, two months, six months, one year etc. and they pay interest to their lenders based on...
(LIBOR) versus the U.S. prime rate. In some circumstances different bases will move at different rates or in different directions, which can cause erratic changes in revenues and expenses.
Yield curve risk: the risk presented by differences between short-term and long-term interest rates. Short-term rates are normally lower than long-term rates, and banks earn profits by borrowing short-term money (at lower rates) and investing in long-term assets (at higher rates). But the relationship between short-term and long-term rates can shift quickly and dramatically, which can cause erratic changes in revenues and expenses.
Repricing risk: the risk presented by assets and liabilities that reprice at different times and rates. For instance, a loan with a variable rate will generate more interest income when rates rise and less interest income when rates fall. If the loan is funded with fixed rated deposits, the bank's interest margin will fluctuate.
Option risk: the risk presented by optionalities embedded in some assets and liabilities. For instance, mortgage loans present significant option risk due to prepayment speeds that change dramatically when interest rates rise and fall. Falling interest rates will cause many borrowers to refinance and repay their loans, leaving the bank with uninvested cash when interest rates have declined. Alternately, rising interest rates cause mortgage borrowers to repay slower, leaving the bank with more loans based on prior, lower interest rates. Option risk is difficult to measure and control.
Model risk: the risk presented by mathematical models used to price asset and liabilities not directly quoted on the market. Interest rate pricing models are based on reasonable assumptions about the behaviour of interest rates that may fail in particular market conditions.
Most banks are asset sensitive, meaning interest rate changes impact asset yields more than they impact liability costs. This is because substantial amounts of bank funding are not affected, or are just minimally affected, by changes in interest rates. The average checking account pays no interest, or very little interest, so changes in interest rates do not produce notable changes in interest expense. However, banks have large concentrations of short-term and/or variable rate loans, so changes in interest rates significantly impact interest income. In general, banks earn more money when interest rates are high, and they earn less money when interest rates are low. This relationship often breaks down in very large banks that rely significantly on funding sources other than traditional bank deposits. Large banks are often liability sensitive because they depend on large concentrations of funding that are highly interest rate sensitive. Large banks also tend to maintain large concentrations of fixed rate loans, which further increases liability sensitivity. Therefore, large banks will often earn more net interest income when interest rates are low.
Megaprojects and interest rate risk
Interest rate risk has been shown to be particularly significant and particularly damaging for very large, one-off investment projects, so-called megaprojects. This is because such projects are typically debt-financed and are prone to end up in what has been called the "debt trap," i.e., a situation where – due to cost overruns, schedule delays, unforeseen interest rate increases, etc. – the costs of servicing debt becomes larger than the revenues available to pay interest on and bring down the debt.Hedging interest rate risk
Interest rate risks can be reduced (hedged) using bondsBond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
, fixed income
Fixed income
Fixed income refers to any type of investment that is not equity, which obligates the borrower/issuer to make payments on a fixed schedule, even if the number of the payments may be variable....
instruments or fixed-for-floating interest rate swaps.
See also
- Bond convexityBond convexityIn finance, convexity is a measure of the sensitivity of the duration of a bond to changes in interest rates, the second derivative of the price of the bond with respect to interest rates . In general, the higher the convexity, the more sensitive the bond price is to decreasing interest rates and...
- Bond durationBond durationIn finance, the duration of a financial asset that consists of fixed cash flows, for example a bond, is the weighted average of the times until those fixed cash flows are received....
- Immunization (finance)Immunization (finance)In finance, interest rate immunization is a strategy that ensures that a change in interest rates will not affect the value of a portfolio. Similarly, immunization can be used to ensure that the value of a pension fund's or a firm's assets will increase or decrease in exactly the opposite amount...
- Risk modelingRisk modelingFor risk modeling in general see risk modelingFinancial risk modeling refers to the use of formal econometric techniques to determine the aggregate risk in a financial portfolio...
- Yield curveYield curveIn finance, the yield curve is the relation between the interest rate and the time to maturity, known as the "term", of the debt for a given borrower in a given currency. For example, the U.S. dollar interest rates paid on U.S...