Interest Rate Risk Dr Said Abu Jalala

Introduction to Interest rates Interest is the "rent" paid to borrow money. The lender receives a compensation for foregoing other uses of their funds, including (for example) deferring their own consumption. The original amount lent is called the "principal," and the percentage of the principal which is paid/payable over a period of time is the "interest rate."

Types of interest rates 1. Simple interest/flat interest: Determined by multiplying the principal by the interest rate (per period). Formula: Interest = Principal × Rate × Time

Types of interest rates 2. Compound interest: Interest which is added to the original principal. New interest is then calculated in subsequent periods, not only on the original principal, but also on the interest that has been added. Formula of Compound Interest Rate where PV = present value FV = future value i = interest rate in percent per period N = number of years

Types of interest rates 3. Nominal interest: It is the interest rate that would appear on a contract from a bank or car dealer and other companies. Nominal interest rates include three risk factors (systematic risks, regulatory risks and inflation risks), plus the time value of the money itself. The systematic risks include the possibility that the borrower will default due to bankruptcy. The regulatory risks include taxation and changes in the law. The inflation risks take into account that the money repaid may not have as much buying power from the perspective of the lender as the money originally lent

Types of interest rates 4. Real interest: This is calculated as - Real interest rate= (nominal interest rate) - (inflation rate). - Thus, if the (expected) inflation rate is 5% and the nominal interest rate is 7%, the (expected) real interest rate is 2%.

Interest Rate Risk Interest rate risk is the risk that the relative value of a security, especially a bond, will worsen due to an interest rate increase. This risk is commonly measured by the bond's duration. The possibility of a reduction in the value of a security, especially a bond, resulting from a rise in interest rates. This risk can be reduced by diversifying the durations of the fixed-income investments that are held at a given time. Interest rate risk is risk to the earnings or market value of a portfolio due to uncertain future interest rates.

Interest Rate Risk Two different perspectives for Interest Rate Risk: A book value perspective, which perceives risk in terms of its effect on accounting earnings, and A market value perspective — sometimes called an economic perspective — which perceives risk in terms of its effect on the market value of a portfolio. A market value perspective — sometimes called an economic perspective — which perceives risk in terms of its effect on the market value of a portfolio. The first perspective is typical in banking, insurance and corporate treasuries, where book value accounting prevails. The latter is typical in a trading or investment management context.

Categories of Interest Rate Risks Interest rate risks can be categorized in different ways, and there is usually some overlap between categories. One approach — that is well suited for a book-value perspective — is to break interest rate risk into three components: term structure risk, term structure risk, basis risk, basis risk, options risk. options risk.

Categories of Interest Rate Risks 1.Term structure risk It is also called re-pricing risk. It is the risk due to changes in the fixed income term structure. It arises if interest rates are fixed on liabilities for periods that differ from those on offsetting assets. One reason may be maturity mismatches. Suppose an insurance company is earning 6% on an asset supporting a liability on which it is paying 4%. The asset matures in two years while the liability matures in ten. In two years, the firm will have to reinvest the proceeds from the asset. If interest rates fall, it could end up reinvesting at 3%. For the remaining eight years, it would earn 3% on the new asset while continuing to pay 4% on the original liability.

Categories of Interest Rate Risks Term structure risk also occurs with floating rate assets or liabilities. If fixed rate assets are financed with floating rate liabilities, the rate payable on the liabilities may rise while the rate earned on the assets remains constant. In general, any occasion on which interest rates are to be reset—either due to maturities or floating rate resets—is called a re-pricing. The date on which it occurs is called the re- pricing date. It is this terminology that motivates the alternative name "re-pricing risk" for tem structure risk. If a portfolio has assets re-pricing earlier than liabilities, it is said to be asset sensitive. This is because near term changes in earnings are going to be driven by interest rate resets on those assets. Similarly, if liabilities re-price earlier, earnings are more exposed to interest rate resets on those liability, and the portfolio is called liability sensitive.

Categories of Interest Rate Risks 2. Basis risk It is the risk due to possible changes in spreads. In fixed income markets, basis risk arises form changes in the relationship between interest rates for different market sectors. If a portfolio holds junk bonds hedged with short Treasury futures, it is exposed to basis risk due to possible changes in the yield spread of junk bonds over Treasuries. Basis risk is another name for spread risk. Book-value and market-value perspectives differ with respect to basis risk. As always, the book value perspective focuses on risk to earnings. If the spread between interest earned on assets and interest paid on liabilities narrows, those earnings will suffer. The economic perspective considers the risk to the portfolio's market value. If a spread narrows or widens, the market values of assets and liabilities may be affected differently—and the net market value of the overall portfolio could suffer.

Categories of Interest Rate Risks 3. Options risk It is the risk due to fixed income options. Options may be bonds or securities. In some respects, options risk is just another component of term structure risk. Payoffs of options depend upon changes in interest rates, which would seem to make options one more source of term structure risk. However, by shorting embedded options, a depository institution can enhance short-term earnings at the expense of long- term earnings.

Categories of Interest Rate Risks The economic perspective on options risk is very different. From that standpoint, options pose immediate risk in the form of changes in their market value. While shorting embedded options can generate income that immediately flows to earnings, it does nothing for market value—the option premiums are offset by the negative market value of the newly shorted options. If the options are shorted at fair prices, the two cancel—and there is no immediate market value impact.

Bonds and Securities Bonds: -A bond is a fixed interest financial asset issued by governments, companies, banks, public utilities and other large entities. -Bonds pay the bearer a fixed amount at specified end date. -A discount bond pays the bearer only at the ending date, while a coupon bond pays the bearer a fixed amount over a specified interval (month, year, etc.) as well as paying a fixed amount at the end date.

Bonds and Securities Security (collateral) -A security is a negotiable interest representing financial value -Securities are broadly categorized into debt and equity securities. -The company or other entity issuing the security is called the issuer. -The legal right given to a creditor by a borrower -Securities may be represented by a certificate or, more typically, by an electronic book entry interest.

Bonds and Securities - Certificates may be bearer, meaning they entitle the holder to rights under the security merely by holding the security, or registered, meaning they entitle the holder to rights only if he or she appears on a security register maintained by the issuer or an intermediary. - They include shares of corporate stock or mutual funds, bonds issued by corporations or governmental agencies, stock options or other options, limited partnership units, and various other formal investment instruments that are negotiable.

Duration Shorter terms have less risk of default/bankruptcy and inflation because the near future is easier to predict than events 20 year off. Longer terms allow for investments in larger projects with higher eventual returns.

Purpose of interest rate risk Deals with the valuation effect of changes in interest rates

New Proposals On Managing Interest Rate Risks The Basle Committee on Banking Supervision has published proposals to be used by banking supervisory authorities in managing interest rate risks. The proposals are: * The board of directors of a bank to approve interest rate risk management policies and procedures, and be informed regularly of the interest rate risk exposure of the bank.

New Proposals On Managing Interest Rate Risks * Effective management of the structure of the bank's business and level of interest rate risks it assumes, with appropriate policies and procedures to control and limit such risks, and resources for evaluating and controlling the risks; * Banks to have risk management functions that are clearly defined, report risk exposures directly to senior management and board of directors, and sufficiently independent from the business lines of the bank;

New Proposals On Managing Interest Rate Risks * Interest rate risk policies and procedures of banks should be clearly defined, consistent with the nature and complexity of the activities, and should address the bank's exposures on a consolidated basis, as also at level of individual affiliates; * Banks to clearly identify the risks inherent in new products and activities, and ensure their being subject to adequate procedures and controls, before introducing or undertaking such activities; major hedging or risk management initiatives should be approved in advance by the bank's board or an appropriate delegated committee;

New Proposals On Managing Interest Rate Risks * Banks to have interest rate risk measurement systems that capture all material sources of such risk and assess the effect of interest risk changes in ways consistent with the scope of their activities; * Banks to measure their vulnerability to loss under stressful market conditions - including breakdown of key assumptions - and consider those risks when establishing and reviewing their policies and limits for interest rate risk;

New Proposals On Managing Interest Rate Risks Banks to establish and enforce operating limits and other practices that maintain exposures within levels consistent with internal policies;Banks to establish and enforce operating limits and other practices that maintain exposures within levels consistent with internal policies; * Banks to have adequate internal controls for the interest rate risk management process, and periodically conduct an independent review of the adequacy and integrity of their risk management processes -- with such reviews available to relevant supervisory authorities;

New Proposals On Managing Interest Rate Risks The supervisory authorities are charged with the task of obtaining from banks sufficient and timely information on these to evaluate the risks, and ensuring that the information take appropriate account of the range of maturities and currencies in each bank's portfolio, and other relevant factors like the distinction between trading and non-trading activities.