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Interest Rate RiskInterest Rate Risk Borne by an Asset That Bears Interest

Interest rate risk

Interest rate risk is defined as the risk borne by an asset that bears interest (Saunders & Cornett, 2010, p. 201). An example of such an asset is the loan or a bond in the case of financial institutions. Banks are required to manage the risk exposure due to the various assets that that they hold that attract interest (Crouchy, Galai, & Mark, 2006, p. 108). Banks are usually asset sensitive. This is because if the fact that these banks heavily rely on customer deposits to avail funds for loan advancements (Jan van den Brink, 2002, p. 68). The importance of this comes up in the fact that while these banks pay less interest on customer deposits, they charge high interest on loans advanced (Amihud & Mendelson, 1991, p. 201). This in means that a change in an asset’s interest rate will have an increasing return to scale or a decreasing return to scale when matching the interest rate between interest rate expenses and the interest income (Williams, 1963, p. 112).

Sources of interest rate risk

Re-pricing Risk

This is the most common cause of interest rate risk that arises from timing differences in the maturity of a bank’s asset in the case of a fixed rate. It may also arise from re-pricing in the case of a floating rate (Carol, 2004, p. 180). An example of this is where a bank funds a long term loan with a short term deposit could be exposed to an interest rate risk if the interests increase and the bank has to earn lower fixed interests yet it is incurring higher interest expenses on the short term deposits (Walter & Smith, 1999, p. 156).

Basis risk

This is another common source of interest rate risk and comes into effect due to the lack of proper correlation between the interest earned and interest paid on different assets or debt instruments that bear the same characteristic when it comes to re-pricing (Bhushan, 1991, p. 98). Unexpected cash flows may arise due to a change in interest rates of these instruments and this may expose the financial institution to the risk of losing income due to the changed cash flows caused by the change in interest rate changes.

Options risk

An option is an instrument that gives the holder the right but no the obligation to sell it or buy it back. There are two common types of option; put option and call option (Buckley, 2000, p. 263). Put option gives the holder the right to sell the instrument at any pre-maturity date while call option gives the holder the right but not the obligation to buy back the instrument (Shaprio, 2000, p. 213). The banks get exposed to interest rate risk when there are several options being redeemed due to the changes in the interest rates in the market (Resti & Sironi, 2007, p. 251).

Measurement of interest rate risk

The measurement of this risk has to do with the models that have been developed to calculate the risks of assets that are not quoted in the market (Celati, 2004, p. 206). Some market conditions provide some assumptions on the interest rate behaviour. These assumptions provide some fundamental basis for coming up with the models that are used to calculate the interest rate risk. However, these models may fail to operate successfully in some market conditions and this form the interest rate risk with regard to the models (Pauline & Sidney, 2007, p. 145).

The most common method used to calculate the interest rate risk is by measuring the mismatch in the interest sensitivity gap as shown by the assets and the liabilities (Baker, 1998, p. 113). This is achieved through the process of establishing each assets and/ or liabilities’ maturity timing or the timing of the interest rate that is reset and then establishing which of the two comes first (Demirgüç-Kunt & Vojislav, 1998, p. 281). The following model indicates the measurement of interest rate risk with relation to the duration and a change in interest rate risk

%∆P = – 2DUR * ∆i/1+I

Where:

  • DUR= duration
  • i = change in interest rate
  • i = current interest rate

Interest’s rate risk management

The management of the interest rate risk is of interest not only to the bank itself but also to the financial sector regulators (Solnik, 2000, p. 153). One such regulator is the Basel committee on bank supervision. According to the Basel committee there are several measures that a bank’s management ought to take in order to manage the different risks the institution is exposed to (Shleifer & Vishny, 1992, p. 128). The most recent regulations on interest rate risk management have are contained in the Basel III which is an advancement of Basel I and II. The main propositions of Basel III on management of liquidity risk are based on Capital ratios and Standards and liquidity standards (Blundell, 2010, p. 5). The capital ratios and standards requirements have to with new capital definitions by banks, new capital buffers, higher minimum ratios, new leverage ratios, and systemic add-ons. The liquidity standards deal with liquidity coverage ratio and new stable funding ration (Jackson, 1999, p. 56). It is thus the responsibility and the obligation of the bank’s management to come up with the definition of the different principles based on proportionality (Tattersall, 2006, p. 67). This aims at pointing at the accountability and responsibility of the management in taking risk management decisions as well as identifying the types of instruments associated with those particular management decisions of the management of the bank (Duffee & DeMarzo, 1999, p. 110).

Conclusion

The management of interest rate risk has presented a few challenges due to the nature of the interest rate risk. Banks are charged with the responsibility of defining their operations that are exposed to the interest rate risk and as such, effective management of interest rate risk will involve the management of the bank adhering to the requirements spelt out by Basel iii. In most cases, there is a correlation between risk and return and as such, many bank managers are willing to bear the risk exposed by the changed in interest rate changes in order to achieve the set income targets.

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