Interest Rate Risk Overview

Citra Aryani Dian Agustina Luna Mantyasih M Ratna Nugrahaningsih

 What is Interest Rate ? What causes Interest Rate to change? What is Interest Rate Risk (IRR)? Where does IRR come from? Why manage IRR? How to Assess IRR Exposure?

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What is Interest Rate ?

A rate which is charged or paid for the use
of money. An interest rate is often expressed as an annual percentage of the principal. It is calculated by dividing the amount of interest by the amount of principal. Interest rates often change as a result of inflation and Federal Reserve Policies. For example, if a lender (such as a bank) charges a customer $90 in a year on a loan of $1000, then the interest rate would be 90/1000 *100% = 9%
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What causes Interest Rate to change?

Political short-term gain Deferred consumption Inflationary expectations Alternative investments Risks of investment Liquidity preference Taxes
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Political short-term gain

Lowering interest rates can give the economy a short-run boost. Under normal conditions, most economists think a cut in interest rates will only give a short term gain in economic activity that will soon be offset by inflation. The quick boost can influence elections. Most economists advocate independent central banks to limit the influence of politics on interest rates.
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Deferred consumption
When money is loaned the lender delays spending the money on consumption goods. Since according to time time preference theory people prefer goods now to goods later, in a free market there will be a positive interest rate.
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Inflationary expectations
Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this.

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Alternative investments
The lender has a choice between using his money in different investments. If he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds.

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Risks of investment
There is always a risk that the borrower will go bankrupt, abscond, or otherwise default on the loan. This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail.
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Liquidity preference
People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realize.

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Taxes
Because some of the gains from interest may be subject to taxes, the lender may insist on a higher rate to make up for this loss.

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What is Interest Rate Risk (IRR)?

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 rates. 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. (http://en.wikipedia.org/wiki/Interest_rate_risk) Interest rate risk is The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. Such changes usually affect securities inversely and can be reduced by diversifying (investing in fixed-income securities with different durations) or hedging (e.g. through an interest rate swap).
(http://www.investopedia.com/terms/i/interestraterisk.asp)

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What is Interest Rate Risk (IRR)?

Accounting Terms

Possibility that the value of an asset will change adversely as interest rates change. For example, when market interest rates rise, fixed-income bond prices fall.
http://www.allbusiness.com/glossaries/interest-raterisk/4943665-1.html

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What is Interest Rate Risk (IRR)?

Insurance Terms

Investment risk associated with the possibility that there is a rise in the interest rates after a fixed income security has been purchased resulting in a decline in that security's price. The longer the maturity date of that security, the greater the exposure of the security's price to interest rate fluctuations.
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What is Interest Rate Risk (IRR)?

Banking Terms

Risk that an interest-earning asset, such as a bank loan, will decline in value as interest rates change. Longer maturity, fixed rate loans (for example, 30-year conventional mortgages) are more sensitive to price risk from changes in rates than variable rate loans.
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What is Interest Rate Risk (IRR)?

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 rates. In general, Interest rate risk is the exposure of banks financial condition to adverse movements in interest rates
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Where does IRR come from?

Banks face four types of interest rate risk:

Repricing risk Yield curve risk Basis risk Option risk

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Repricing risk
The risk that arises from timing differences or mismatches in the maturity and interest rate changes of a banks assets and liabilities For example, if a long-term fixed-rate asset is funded with a short-term deposit, interest income from the asset remains fixed over its life, while the interest expense changes each time the deposit is renewed. Because interest income is fixed and interest expense can move with market rate changes, net interest income and underlying economic value increase or decrease in response to market rates
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Yield curve risk

Another form of repricing risk, is the risk that changes in market interest rates may have different effects on yields or prices on similar instruments with different maturities 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 longterm 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
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Basis risk
Basis risk is the risk that changes in market interest rates may have different effects on rates received or paid on instruments with similar repricing characteristics For example, a variable-rate loan whose rate is based on the three-month Treasury bill rate that is funded with three-month certificates of deposit Because both instruments have a similar repricing interval, there is no repricing risk Yet changes in the spread between the two market interest rates can cause Bank As net interest income to expand and contract
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Options risk
Options risk is the risk that arises from implicit and explicit options in a banks assets and liabilities

For instance, provisions in agreements that allow loan customers to prepay their loans or that allow deposit holders to withdraw their funds early, with little or no penalty
These options, if exercised, can affect net interest income and underlying economic value
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Why manage IRR?

Changes in interest rates, affect a bank's earnings by changing its net interest income and the level of other interest sensitive income and operating expenses also affects the underlying value of the bank's assets, liabilities and off-balance sheet instruments because the present value of future cash flows change when interest rates change
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How to Assess IRR Exposure?

Two most common perspectives for assessing a bank's interest rate risk exposure: Earnings perspective
Economic value perspective

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Earnings Perspective (Book Value Perspective)

Traditional approach to interest rate risk assessment taken by many banks which perceives risk in terms of its effect on accounting earnings Variation in earnings is an important focal point for interest rate risk analysis Because reduced earnings - threaten the financial stability of an institution by undermining its capital adequacy and by reducing market confidence Component of earnings given most attention is net interest income (i.e. the difference between total interest income and total interest expense)
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Economic Value Perspective (Market Value Perspective)

Perceives risk in terms of its effect on the market value of a portfolio Variation in market interest rates can affect the economic value of a bank's assets, liabilities and off-balance sheet positions Economic value of a bank can be viewed as the present value of bank's expected net cash flows Defined as the expected cash flows on assets minus the expected cash flows on liabilities

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