Answer To: The assessment for this module is by means of an assignment and this assignment accounts for 100% of...
Robert answered on Dec 20 2021
1 | P a g e
INTEREST RATE RISK
Interest rate risk is a risk in which the investment value changes due to changes in the interest
rates. Mostly bonds are affected by interest rate risk. It does not have much impact on stocks as
stock does not have any interest rate. When interest rate rises then the price of the bond will
definitely fall because the opportunity cost of holding a bond decreases as investors are getting
more yield by investing in other bonds which has higher interest rates.
Bank manages the interest rates by matching the maturity of its liabilities with the maturity of its
assets. Provision expenses have more influence on the net interest incomes than changes in the
short term interest or slope of yield curve. The effect of changes in interest rate can be explained
in two ways: first from rate sensitivity analysis of bank’s balance sheet and second, economic
analysis of the response of assets to the interest rates. From the point of view of balance sheet
indicators banks should start from pristine liquidity ratios. Banks hold high level of cash, huge
amount of funds and billions in their reserve and these all sources combat interest rate risk
losses. The interest rate risk greatly depends upon the balance sheet of a bank. This is because
the interest rate risk is calculated keeping in mind the maturity of all the liabilities and the
maturity of the assets. As mentioned above, the bonds are the most affected assets due to this
interest rate risk. There are certain ratios which are used while calculating the interest rate risk as
decided by the bank. With the help of these ratios, we get to know a bank can see its overall
picture as to where the financial institutions (banks) actually stand.
There is also a catch in determining the interest rate risk by the banks. It is considered to be
cyclical phenomena. That is to say that opposite happens with the change in the interest rate risk.
When the interest rate risk increases, the value of the bonds or any other such marketable
2 | P a g e
securities declines or reduces. On the contrary, when the interest rate risk declines, i.e. when the
banks decide to reduce the rate due to some reasons the value of such bonds increases or rises,
which is beneficial for the owner of the bonds. Generally, the financial institutions do not have
any major issues with this interest rate risk. Still, we find that interest risk rate revolve around the
mortgage-backed securities (MBS). These mortgage-backed securities are generally the valuable
assets of the banks or the financial institution or the banks of a country. There were major
mortgage crisis in U.S. in the past, but still there were a huge amount of mortgaged-backed
securities. There is also a unique feature of these mortgage-backed securities. This is because
with the increase in the interest rate risk, the amount of repayment to the owner of the bond or
the mortgaged-backed securities reduces to a great number. It is because of this the duration of
the mortgaged-based securities will increase ultimately.
The calculation of the interest rate risk is also a very complicated task to do as it involves the
maturity of all the liabilities and the assets of the financial institution as mentioned in the balance
sheet of the bank. “It is based on the stimulating movement of one or more yield curves, which
uses the Health Jarrow Morton framework” (FXSTREET. (2012). Banking Risks. Available:
http://mediaserver.fxstreet.com. Last accessed 09/05/2012). This framework has been used just
to ensure that the yield curves give consistent and accurate result and no arbitrage is being made
possible. This method of calculation was originally developed in the early 1990s by David Heath
in the Cornell University. This framework help in determining the interest rate risk in the most
appropriate and accurate way, so that there are no problems faced in the future regarding the
same.
The interest rate risk is also being considered significant and quite damaging rates, in the cases
of mega project. In order to accomplish the mission of a megaproject, one has to get a lot of
3 | P a g e
debts, as completing of a megaproject requires a huge amount of debts. The person who is
initiating the megaproject is considered to be in a debt-trap. This is because as it requires a lot of
time in the completion of the project, the interest to be paid to the creditors of the person gets
delayed. As the person is in the situation of debt-trap, it becomes difficult for them to overdo the
costs incurred with the revenue earned by the person in the completion of the project. Hence we
can say that the interest rate risk is a very significant and an important rate of the bank. “Actually
there are many interest rate risks faced by the bank” (Comptroller of currencies. (1997). Interest
RateRisk. Available:https://docs.google.com/viewer?a=v&q=cache:muEzRWGbMoYJ:www.occ
.treas.gov/publications/publications-by-type/comptrollers-
handbook/irr.pdf+The+interest+rate+risk+greatly+depends+upon+the+balance+sheet+ last
accessed 09/05/2012). These are Basis risk, Yield curve risk, Re-pricing risk, Option risk, and
model risk. The basis risk refers to that presented risk where the yields on the various assets and
the costs on liabilities of the bank are done on different basis. This is what we call as the basis
risk. The yield curve risk is another form of risk in the banks. In this the risk is presented
between the short term and the long term interest rates. This is known as the yield curve risk. Re-
pricing risk refers to that risk which is presented by the different types of rates of assets and the
liabilities at different levels. The option risk refers to the risk, with the help of certain options
surrounding the various assets and various liabilities of the financial institution. Model risk is
totally based on the mathematical model on the basis of which the price and the value of the
assets and liabilities are determined, along with the interest risk rate of the banks. Hence, with
given amount of information, the interest rate risk can be easily analyzed and can be critically
reviewed as well.
https://docs.google.com/viewer?a=v&q=cache:muEzRWGbMoYJ:www.occ.treas.gov/publications/publications-by-type/comptrollers-handbook/irr.pdf+The+interest+rate+risk+greatly+depends+upon+the+balance+sheet
https://docs.google.com/viewer?a=v&q=cache:muEzRWGbMoYJ:www.occ.treas.gov/publications/publications-by-type/comptrollers-handbook/irr.pdf+The+interest+rate+risk+greatly+depends+upon+the+balance+sheet
https://docs.google.com/viewer?a=v&q=cache:muEzRWGbMoYJ:www.occ.treas.gov/publications/publications-by-type/comptrollers-handbook/irr.pdf+The+interest+rate+risk+greatly+depends+upon+the+balance+sheet
4 | P a g e
FXSTREET. (2012). Banking Risks. Available: http://mediaserver.fxstreet.com. Last accessed
09/05/2012
Comptroller of currencies.
(1997). InterestRateRisk. Available:https://docs.google.com/viewer?a=v&q=cache:muEzRWGb
MoYJ:www.occ.treas.gov/publications/publications-by-type/comptrollers-
handbook/irr.pdf+The+interest+rate+risk+greatly+depends+upon+the+balance+sheet+ last
accessed 09/05/2012
https://docs.google.com/viewer?a=v&q=cache:muEzRWGbMoYJ:www.occ.treas.gov/publications/publications-by-type/comptrollers-handbook/irr.pdf+The+interest+rate+risk+greatly+depends+upon+the+balance+sheet
https://docs.google.com/viewer?a=v&q=cache:muEzRWGbMoYJ:www.occ.treas.gov/publications/publications-by-type/comptrollers-handbook/irr.pdf+The+interest+rate+risk+greatly+depends+upon+the+balance+sheet
https://docs.google.com/viewer?a=v&q=cache:muEzRWGbMoYJ:www.occ.treas.gov/publications/publications-by-type/comptrollers-handbook/irr.pdf+The+interest+rate+risk+greatly+depends+upon+the+balance+sheet
5 | P a g e
LIQUIDITY RISK
Liquidity of the assets is one of the most important factors of any of the company or any
financial institutions especially the banks. Liquidity of any asset refers to the time or the duration
at which an asset of a company can be easily converted in cash. It is very much profitable for any
financial institution to have a huge amount of liquid assets. This is because these institutions can
be in the need of cash anytime and anywhere. The more is the nature of the asset is liquid, the
more it will be easier and more convenient for any company. There is also a risk involved in the
liquidity of the assets. This risk is a financial risk which arises due to the uncertain (not planned)
liquidity of the assets of the financial institutions.
A bank or a financial institution may lose the liquidity of its assets if there is a fall in the credit
rating of the company. This is obviously harmful for the company or the bank as it has an
adverse effect on the day-to-day workings of the company. It leads to the outflow of certain
amount of cash from the company. It also deteriorates the relation with the customers as people
will not be interested in doing the business with the effected company or the financial
institutions.no company or even the government of any respective country will lend its hands in
giving loans to the effected company or the bank itself. “A firm or any banks is also open to the
liquidity risk” (RiskGlossary.com. 2012. RiskGlossary.com. [ONLINE] Available
at:http://www.riskglossary.com, Accessed 09 May 2012), if the market on which they depend is
a subject to the loss of liquidity of the assets of a company or a bank.
The liquidity risk may even be considered as the risk which helps in compounding the other risk
of the company or any firm or the financial institutions. There are various problems which can
arise due to the liquidity risk. If a company or an organization is in a position of an illiquid asset,
http://www.riskglossary.com/
6 | P a g e
the total risk of the company or the financial institutions gets compounded. This happens because
these illiquid assets of the company have a very limited ability to liquidate the necessary assets
of the company. This adds to the market risk of the company or the financial institution. If a
company owes a certain amount to a person or some other company, it has to make the payments
at the proper time and clear all its credits. But if the company is out of cash as such, they have to
make sure that they raise funds from different sources make the payments. The raising of funds
is not an easy task for the officials of the company. This risk of the company leads to the
compounding of the credit risk of the company or the financial institutions. The position of the
organization can be reduced or hedged as and when required against the market risk of the
company. After all this, still the company can entail the liquidity risk.
The liquidity risk has to be managed as well with other risks of the firm or the business which
includes the market risk, credit risk, and other risks borne by the company as a whole. The
liquidity risk has the tendency and the willingness to compound the other risks mentioned in the
above sentences. This is obviously a difficult situation for any...