interest rate risk dr said abu jalala. introduction to interest rates interest is the...

Interest Rate RiskInterest Rate Risk

Dr Said Abu JalalaDr Said Abu Jalala

Introduction to Interest ratesIntroduction to Interest ratesInterestInterest is the "rent" paid to borrow money. The is the "rent" paid to borrow money. The lender receives a compensation for foregoing other lender receives a compensation for foregoing other uses of their funds, including (for example) deferring uses of their funds, including (for example) deferring their own consumption.their own consumption.

The original amount lent is called the "principal," and The original amount lent is called the "principal," and the percentage of the principal which is paid/payable the percentage of the principal which is paid/payable over a period of time is the "interest rate."over a period of time is the "interest rate."

Types of interest ratesTypes of interest rates

1. Simple interest/flat interest:1. Simple interest/flat interest:

Determined by multiplying the principal by the Determined by multiplying the principal by the interest rate (per period). Formula:interest rate (per period). Formula:

Interest = Principal × Rate × TimeInterest = Principal × Rate × Time

Types of interest ratesTypes of interest rates2. 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 RateFormula of Compound Interest Rate

where PV = present value FV = future value where PV = present value FV = future value i = interest rate in percent per period N = number of i = interest rate in percent per period N = number of yearsyears

Types of interest ratesTypes 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 The systematic risks include the possibility that the borrower will default due to bankruptcy.borrower will default due to bankruptcy.The regulatory risks include taxation and changes in The regulatory risks include taxation and changes in the law. the law. The inflation risks take into account that the money The inflation risks take into account that the money repaid may not have as much buying power from the repaid may not have as much buying power from the perspective of the lender as the money originally lentperspective of the lender as the money originally lent

Types of interest ratesTypes 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 RiskInterest Rate Risk

Interest rate riskInterest rate risk is the risk that the relative value of a is the risk that the relative value of a security, especially a bond, will worsen due to an security, especially a bond, will worsen due to an interest rate increase. This risk is commonly measured interest rate increase. This risk is commonly measured by the bond's duration. by the bond's duration.

The possibility of a reduction in the value of a security, The possibility of a reduction in the value of a security, especially a bond, resulting from a rise in interest especially a bond, resulting from a rise in interest rates. This risk can be reduced by diversifying the rates. This risk can be reduced by diversifying the durations of the fixed-income investments that are durations of the fixed-income investments that are held at a given time.held at a given time.

Interest rate risk is risk to the earnings or market value Interest rate risk is risk to the earnings or market value of a portfolio due to uncertain future interest rates.of a portfolio due to uncertain future interest rates.

Interest Rate RiskInterest Rate RiskTwo different perspectives for Interest Rate Risk:Two different perspectives for Interest Rate Risk:

A book value perspective, which perceives risk A book value perspective, which perceives risk in terms of its effect on accounting earnings, in terms of its effect on accounting earnings, andand

A market value perspective—sometimes called A market value perspective—sometimes called an economic perspective—which perceives risk an economic perspective—which perceives risk in terms of its effect on the market value of a in terms of its effect on the market value of a portfolio.portfolio.

The first perspective is typical in banking, The first perspective is typical in banking, insurance and corporate treasuries, where book insurance and corporate treasuries, where book value accounting prevailsvalue accounting prevails. . The latter is typical The latter is typical in a trading or investment management in a trading or investment management contextcontext..

Categories of Interest Rate RisksCategories of Interest Rate Risks

Interest rate risks can be categorized in Interest rate risks can be categorized in different ways, and there is usually different ways, and there is usually some overlap between categoriessome overlap between categories. . One One approach—that is well suited for a bookapproach—that is well suited for a book--value perspective—is to break interest value perspective—is to break interest rate risk into three componentsrate risk into three components::

term structure riskterm structure risk,,

basis riskbasis risk,,

options riskoptions risk..

Categories of Interest Rate RisksCategories of Interest Rate Risks1.1. Term structure risk Term structure risk

It is It is also calledalso called re-pricing risk. It re-pricing risk. It is the risk due to is the risk due to changes in thechanges in the fixed income term structure.fixed income term structure.

It arises if interest rates are fixed on liabilities for It arises if interest rates are fixed on liabilities for periods that differ from those on offsetting assetsperiods that differ from those on offsetting assets. . One reason may be maturity mismatchesOne reason may be maturity mismatches. .

Suppose an insurance company is earning 6% on an Suppose an insurance company is earning 6% on an asset supporting a liability on which it is paying 4%asset supporting a liability on which it is paying 4%. . The asset matures in two years while the liability The asset matures in two years while the liability matures in tenmatures in ten. . In two years, the firm will have to In two years, the firm will have to reinvest the proceeds from the assetreinvest the proceeds from the asset. . If interest rates If interest rates fall, it could end up reinvesting at 3%fall, it could end up reinvesting at 3%. . For the For the remaining eight years, it would earn 3% on the new remaining eight years, it would earn 3% on the new asset while continuing to pay 4% on the original asset while continuing to pay 4% on the original liabilityliability. .

Categories of Interest Rate RisksCategories of Interest Rate RisksTerm structure risk also occurs withTerm structure risk also occurs with floating rate floating rate assets or liabilitiesassets or liabilities. . If fixed rate assets are financed If fixed rate assets are financed with floating rate liabilities, the rate payable on the with floating rate liabilities, the rate payable on the liabilities may rise while the rate earned on the assets liabilities may rise while the rate earned on the assets remains constantremains constant..

In general, any occasion on which interest rates are to be resetIn general, any occasion on which interest rates are to be reset—either due to maturities or floating rate resets—is called a—either due to maturities or floating rate resets—is called a re-re-pricingpricing. . The date on which it occurs is called theThe date on which it occurs is called the re-pricing re-pricing datedate. . It is this terminology that motivates the alternative name It is this terminology that motivates the alternative name ""re-pricing riskre-pricing risk" " for tem structure riskfor tem structure risk..

If a portfolio has assets re-pricing earlier than liabilities, it is said If a portfolio has assets re-pricing earlier than liabilities, it is said to be to be asset sensitiveasset sensitive. This is because near term changes in . This is because near term changes in earnings are going to be driven by interest rate resets on those earnings are going to be driven by interest rate resets on those assets. Similarly, if liabilities re-price earlier, earnings are more assets. Similarly, if liabilities re-price earlier, earnings are more exposed to interest rate resets on those liability, and the exposed to interest rate resets on those liability, and the portfolio is called portfolio is called liability sensitiveliability sensitive..

Categories of Interest Rate RisksCategories of Interest Rate Risks2. Basis risk2. Basis risk

It is the risk due to possible changes in spreads. It is the risk due to possible changes in spreads. In fixed income markets, basis risk arises form changes in the In fixed income markets, basis risk arises form changes in the relationship between interest rates for different market sectors.relationship between interest rates for different market sectors.

If a portfolio holds junk bonds hedged with short Treasury futures, it is 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 exposed to basis risk due to possible changes in the yield spread of junk bonds over Treasuries. Basis risk is another name for spread junk bonds over Treasuries. Basis risk is another name for spread risk.risk.

Book-value and market-value perspectives differ with respect to basis Book-value and market-value perspectives differ with respect to basis risk. As always, the book value perspective focuses on risk to risk. As always, the book value perspective focuses on risk to earnings. If the spread between interest earned on assets and earnings. If the spread between interest earned on assets and interest paid on liabilities narrows, those earnings will suffer. interest paid on liabilities narrows, those earnings will suffer.

The economic perspective considers the risk to the portfolio's market The economic perspective considers the risk to the portfolio's market value. If a spread narrows or widens, the market values of assets and 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 liabilities may be affected differently—and the net market value of the overall portfolio could suffer.overall portfolio could suffer.


3. Options risk3. Options riskIt is the risk due to fixed incomeIt is the risk due to fixed income options.options.

Options may be bondsOptions may be bonds or securitiesor securities..

In some respects, options risk is just another In some respects, options risk is just another component of term structure riskcomponent of term structure risk. .

Payoffs of options depend upon changes in interest Payoffs of options depend upon changes in interest rates, which would seem to make options one more rates, which would seem to make options one more source of term structure risk. However, by shorting source of term structure risk. However, by shorting embedded options, a depository institution can embedded options, a depository institution can enhance short-term earnings at the expense of long-enhance short-term earnings at the expense of long-term earnings.term earnings.


The economic perspective on options risk is The economic perspective on options risk is very differentvery different. . From that standpoint, options From that standpoint, options pose immediate risk in the form of changes in pose immediate risk in the form of changes in their market valuetheir market value. . While shorting embedded While shorting embedded options can generate income that immediately options can generate income that immediately flows to earnings, it does nothing for market flows to earnings, it does nothing for market value—the option premiums are offset by the value—the option premiums are offset by the negative market value of the newly shorted negative market value of the newly shorted optionsoptions. .

If the options are shorted at fair prices, the two If the options are shorted at fair prices, the two cancel—and there is no immediate market cancel—and there is no immediate market value impactvalue impact..

Bonds and SecuritiesBonds and Securities

BondsBonds: : - A bond is a fixed interest financial asset issued A bond is a fixed interest financial asset issued

by governments, companies, banks, public by governments, companies, banks, public utilities and other large entitiesutilities and other large entities. .

- Bonds pay the bearer a fixed amount at Bonds pay the bearer a fixed amount at specified end datespecified end date. .

- A discount bond pays the bearer only at the A discount bond pays the bearer only at the ending date, while a coupon bond pays the ending date, while a coupon bond pays the bearer a fixed amount over a specified interval bearer a fixed amount over a specified interval ((month, year, etcmonth, year, etc.) .) as well as paying a fixed as well as paying a fixed amount at the end dateamount at the end date. .


Security Security ((collateralcollateral))

- AA securitysecurity is ais a negotiable interest negotiable interest representing financial valuerepresenting financial value

- Securities are broadly categorized intoSecurities are broadly categorized into debtdebt andand equityequity securitiessecurities. .

- The company or other entity issuing the The company or other entity issuing the security is called the issuersecurity is called the issuer..

- The legal right given to a creditor by aThe legal right given to a creditor by a borrowerborrower

- Securities may be represented by a Securities may be represented by a certificate or, more typically, by an certificate or, more typically, by an electronic book entry interestelectronic book entry interest..


- Certificates may be bearer, meaning they entitle - Certificates may be bearer, meaning they entitle the holder to rights under the security merely the holder to rights under the security merely by holding the security, or registered, meaning by holding the security, or registered, meaning they entitle the holder to rights only if he or she they entitle the holder to rights only if he or she appears on a security register maintained by appears on a security register maintained by the issuer or an intermediarythe issuer or an intermediary..

- They include shares of corporate- They include shares of corporate stock orstock or mutual funds,mutual funds, bonds issued by corporations or bonds issued by corporations or governmental agenciesgovernmental agencies, , stock optionsstock options or other or other options, limited partnership units, and various options, limited partnership units, and various other formal investment instruments that are other formal investment instruments that are negotiable.negotiable.

DurationDuration

Shorter terms have less risk of Shorter terms have less risk of default/bankruptcy and inflation because default/bankruptcy and inflation because the near future is easier to predict than the near future is easier to predict than events 20 year off.events 20 year off.

Longer terms allow for investments in Longer terms allow for investments in larger projects with higher eventual larger projects with higher eventual returns. returns.

Purpose of interest rate riskPurpose of interest rate risk

Deals with the valuation effect of changes in interest rates

New Proposals On Managing Interest Rate RisksNew Proposals On Managing Interest Rate Risks The Basle Committee on Banking The Basle Committee on Banking Supervision has published proposals to be Supervision has published proposals to be used by banking supervisory authorities used by banking supervisory authorities in managing interest rate risks. The in managing interest rate risks. The proposals are: proposals are:

* The board of directors of a bank to * The board of directors of a bank to approve interest rate risk management approve interest rate risk management policies and procedures, and be informed policies and procedures, and be informed regularly of the interest rate risk regularly of the interest rate risk exposure of the bank.exposure of the bank.

New Proposals On Managing Interest Rate RisksNew Proposals On Managing Interest Rate Risks

* Effective management of the structure of * Effective management of the structure of the bank's business and level of interest the bank's business and level of interest rate risks it assumes, with appropriate rate risks it assumes, with appropriate policies and procedures to control and policies and procedures to control and limit such risks, and resources for limit such risks, and resources for evaluating and controlling the risks;evaluating and controlling the risks;

* Banks to have risk management functions * Banks to have risk management functions

that are clearly defined, report risk that are clearly defined, report risk exposures directly to senior management exposures directly to senior management and board of directors, and sufficiently and board of directors, and sufficiently independent from the business lines of independent from the business lines of the bank; the bank;


* Interest rate risk policies and procedures of banks * Interest rate risk policies and procedures of banks should be clearly defined, consistent with the nature should be clearly defined, consistent with the nature and complexity of the activities, and should address and complexity of the activities, and should address the bank's exposures on a consolidated basis, as also the bank's exposures on a consolidated basis, as also at level of individual affiliates;at level of individual affiliates;

* Banks to clearly identify the risks inherent in new * Banks to clearly identify the risks inherent in new products and activities, and ensure their being subject products and activities, and ensure their being subject to adequate procedures and controls, before to adequate procedures and controls, before introducing or undertaking such activities; major introducing or undertaking such activities; major hedging or risk management initiatives should be hedging or risk management initiatives should be approved in advance by the bank's board or an approved in advance by the bank's board or an appropriate delegated committee;appropriate delegated committee;


* Banks to have interest rate risk measurement * Banks to have interest rate risk measurement systems that capture all material sources of systems that capture all material sources of such risk and assess the effect of interest risk such risk and assess the effect of interest risk changes in ways consistent with the scope of changes in ways consistent with the scope of their activities;their activities;

* Banks to measure their vulnerability to loss * Banks to measure their vulnerability to loss under stressful market conditions - including under stressful market conditions - including breakdown of key assumptions - and consider breakdown of key assumptions - and consider those risks when establishing and reviewing those risks when establishing and reviewing their policies and limits for interest rate risk; their policies and limits for interest rate risk;


• Banks to establish and enforce operating limits Banks to establish and enforce operating limits and other practices that maintain exposures and other practices that maintain exposures within levels consistent with internal policies; within levels consistent with internal policies;

* Banks to have adequate internal controls for the * Banks to have adequate internal controls for the interest rate risk management process, and interest rate risk management process, and periodically conduct an independent review of periodically conduct an independent review of the adequacy and integrity of their risk the adequacy and integrity of their risk management processes -- with such reviews management processes -- with such reviews available to relevant supervisory authorities; available to relevant supervisory authorities;


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

interest rate risk dr said abu jalala. introduction to interest rates interest is the...

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