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Information about Interest Rate Risk

Interest rate risk is the risk that the relative value of an interest-bearing asset, such as a loan or a bond, will worsen due to an interest rate increase. 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, the oldest of the many techniques now used to manage interest rate risk. Asset liability management is a common name for the complete set of techniques used to manage risk within a general enterprise risk management framework.

Calculating interest rate risk

Interest rate risk analysis is almost always based on simulating movements in one or more yield curves 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:
  • 1. Marking to market, calculating the net market value of the assets and liabilities, sometimes called the "market value of portfolio equity"
  • 2. Stress testing this market value by shifting the yield curve in a specific way. Duration is a stress test where the yield curve shift is parallel
  • 3. Calculating the Value at Risk of the portfolio
  • 4. Calculating the multiperiod cash flow or financial accrual income and expense for N periods forward in a deterministic set of future yield curves
  • 5. Doing step 4 with random yield curve movements and measuring the probability distribution of cash flows and financial accrual income over time.
  • 6. Measuring the mismatch of the interest sensitivity gap of assets and liabilities, by classifying each asset and liability by the timing of interest rate reset or maturity, whichever comes first.

Hedging interest rate risk

Interest rate risks can be hedged using fixed income instruments or interest rate swaps. Interest rate risk can be reduced by buying bonds with shorter duration, or by entering into a fixed-for-floating interest rate swap.

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See also

bond is a debt security, in which the authorized issuer owes the holders a debt and is obliged to repay the principal and interest (the coupon) at a later date, termed maturity.
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In finance, a fixed rate bond is a bond with a fixed coupon (interest) rate, as opposed to a floating rate note. A fixed rate bond is a long term debt paper that carries a predetermined interest rate.
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In finance, duration is the weighted average maturity of a bond's cash flows or of any series of linked cash flows. Then the duration of a zero coupon bond with a maturity period of n years is n years.
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asset liability management is the practice of managing risks that arise due to mismatches between the assets and liabilities (debts and assets) of the bank.

Banks face several risks such as the liquidity risk, interest rate risk, credit risk and operational risk.
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Risk management is the human activity which integrates recognition of risk, risk assessment, developing strategies to manage it, and mitigation of risk using managerial resources.
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yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency. For example, the current U.S. dollar interest rates paid on U.S.
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The Heath-Jarrow-Morton framework is a general framework to model the evolution of interest rates (forward rates in particular) for risk management in general and asset liability management in particular. The HJM framework originates from the work of David Heath, Robert A.
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yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency. For example, the current U.S. dollar interest rates paid on U.S.
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yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency. For example, the current U.S. dollar interest rates paid on U.S.
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Robert Alan Jarrow is the Ronald P. and Susan E. Lynch Professor of Investment Management at the Johnson Graduate School of Management, Cornell University. He graduated magna cum laude from Duke University in 1974 with a major in mathematics, received an MBA from Dartmouth College
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yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency. For example, the current U.S. dollar interest rates paid on U.S.
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For other meanings of duration, see Duration (disambiguation).
A duration is an amount of time or a particular time interval. For example, an event in the common sense has a duration greater than zero (but not very long), but in certain specialized senses
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yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency. For example, the current U.S. dollar interest rates paid on U.S.
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Value at Risk (VaR) is the maximum loss not exceeded with a given probability defined as the confidence level, over a given period of time. It is commonly used by security houses or investment banks to measure the market risk of their asset portfolios (market value at risk
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yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency. For example, the current U.S. dollar interest rates paid on U.S.
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yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency. For example, the current U.S. dollar interest rates paid on U.S.
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The 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
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An interest rate swap is a derivative in which one party exchanges a stream of interest payments for another party's stream of cash flows. Interest rate swaps can be used by hedgers to manage their fixed or floating assets and liabilities.
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In finance, convexity is a measure of the sensitivity of the duration of a bond to changes in interest rates.

Calculation of convexity

Duration is a linear measure or 1st derivative of how the price of a bond changes in response to interest rate changes.
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Credit risk is the risk of loss due to a debtor's non-payment of a loan or other line of credit (either the principal or interest (coupon) or both).

Faced by lenders to consumers

Main article: Consumer credit risk

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In finance, duration is the weighted average maturity of a bond's cash flows or of any series of linked cash flows. Then the duration of a zero coupon bond with a maturity period of n years is n years.
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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 insure that the value of a pension fund's or a firm's assets will increase or decrease in exactly the
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Legal and regulatory risk: Sometimes governments change the law in a way that adversely affects a bank's position.

The Risk Principle

The Risk Principle is an area of law closely tied to legal causation in negligence.
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Liquidity risk arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade that asset. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects
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Market risk is the risk that the value of an investment will decrease due to moves in market factors. The four standard market risk factors are:
  • Equity risk, or the risk that stock prices will change.

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operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. Although the risks apply to any organisation in business it is of particular relevance to the banking regime where regulators are
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Settlement risk is the risk that a counterparty does not deliver a security or its value in cash as per agreement when the security was traded after the other counterparty or counterparties have already delivered security or cash value as per the trade agreement.
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Volatility risk in financial markets is the likelihood of fluctuations in the exchange rate of currencies. Therefore, it is a probability measure of the threat that an exchange rate movement poses to an investor's portfolio in a foreign currency.
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Risk modeling refers to the use of formal econometric techniques to determine the aggregate risk in a financial portfolio. Risk modeling is one of many subtasks within the broader area of financial modeling.
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