What is Interest Rate Risk: Types of Interest Rate Risk

Interest Rate Risk

Interest rate risk is the that an organisation will make  a lower profit, or even a loss, due to adverse movements in interest rates. This is also known as interest rate exposure.

The management of interest rate risk is one of the crucial risk management activities for a treasurer. Generally speaking, there are two types of interest rates that may be paid on borrowing or received for deposits:

  1. Floating interest rates, which vary in line with a market rate such as LIBOR.
  2. Fixed interest rates, which remain the same for a specified period regardless of the movements in market rates.

The use of hedging instruments enables a treasure to limit the adverse effect of market movements on floating rates, or to benefit from market movements when the organisation has a fixed rate profile. It is also possible to effectively change floating rates to fixed, and vice versa, to change the currency in which interest is paid or received, or to  change the maturity profile.

The hedging instruments that are particularly appropriate for the management of interest rate risk include:

  1. Option, Including Caps, Floors and Collars:
  2. Interest Rate Forwards:
  3. Swaps;and
  4. Futures

Most organisations have a target for the ratio of their fixed rate debt to floating rate debt. The use of hedging instruments, particularly interest rate swaps, allows the desired ratio to be created without changing the underlying debt. Occasionally market conditions make it unattractive for particular organisations to borrow in either the fixed or floating rate markets. The use of swaps allows the organisation to borrow at a floating rate of interest, and to convert this to a fixed rate obligation.

Types of Interest Rate Risk

The types of interest rate risk are as follows:

  1. Gap or Mismatch Risk: A gap or mismatch risk arises from holding assets and liabilities and off-balance sheet items with different principal amounts, maturity dates or repricing dates, thereby creating exposure to unexpected changes in the level of market interest rates.
  2. Basis Risk: Market interest rates of various instruments seldom change by the same degree during a given period of time. The risk that the interest rate of different assets, liabilities and off-balance sheet items may change in different magnitude is termed as basis risk. The degree of basis is fairly high in respects of banks that create composite assets out of composite liabilities. The Loan book in  India is funded out of a composite liability portfolio and is exposed to a considerable degree of basis risk. The basis risk is quite visible in volatile interest rate scenarios. When the variation in market interest rate causes the nil to expand, the banks have experienced favorable basis shifts and if the interest rate movement causes the NII to contract, the basis has moved against the banks.
  3. Embedded Option Risk: Significant changes in market interest rates create another source of risk to bank’s’ profitability by encouraging prepayment of cash credit/put options on bond/debentures and/or premature withdrawal of term deposits before their stated maturities. The embedded option risk is becoming a reality in India and is experience in volatile situations. The faster and higher the magnitude of changes in interest rate, the greater will be the embedded option risk to the banks’ NII. Thus , banks should evolve scientific techniques to estimate the probable embedded options and adjust the Gap statements to realistically estimate the risk profiles in their balance sheet. Banks should also endeavor for stipulating appropriate penalties based on opportunity costs to stem the exercise of options, which is always to the disadvantage of banks.
  4. Yield Curve Risk: In a floating interest rate scenario, banks may price their assets and liabilities based on different benchmarks, Tbs yield, fixed deposit rates, call money rates, MIBOR, etc in case the banks use two different instruments maturing at different time horizon for pricing their assets and liabilities, any non-parallel movements in yield curves would affect the NII. The movements in yield curve are rather frequent when the economy moves through business cycles. Thus , banks should evaluate the m,movement in yield curves and the impact of that on the portfolio valves and income.
  5. Price Risk: Price risk occurs when assets are sold before their stated maturities. In the financial market, bond prices and yield are inversely related, the price risk is closely associated with the trading book, which is created for making profit out of short-term movements in interest rates. Banks have an active trading book should therefore , formulate policies to limit the portfolio size holding period, duration, defeasance period, stop loss limits, marketing to market, etc.
  6. Reinvestment Risk: Uncertainty with regard to interest rate at which the future cash flows could be reinvested is called reinvestment risk. Any mismatches in cash flows would expose the banks to variations in NII as the market rates move in different directions.
  7. Net Interest Position Risk: The size of non-paying liabilities is one of the significant factors contributing towards profitability of banks. When banks have more earning assets than paying liabilities, interest rate risk arises when the market interest rates adjust downwards. Thus, banks with positive net interest rate declines and increases when interest rate rises. Thus large float is a natural hedge against the variations in interest rates.

Effect of Interest Rate Risk

Changers in interest rates can have adverse effects both on a bank’s  earnings  and its economic value. This has given rise to following perspectives for assessing a bank’s interest rate risk exposure:

  1. Earnings Perspective: In the earnings perspectives the focus of analysis is the impact of changes in interest rates on accrual or reported earnings. This is the traditional approach to interest rate risk assessment taken by many banks. Various in earnings is an important focal point for interest rate risk analysis because reduced earnings or ought right losses can threaten the financial stability of an institution by undermining its capital adequacy and by reducing market confidence.

In this regard, the component of earnings that has traditionally received the most attention is net interest income difference between total interest income and total interest . This focus reflects both the importance of net interest income in banks’overall earnings and its direct and easily understood link to changes in interests rates.