What is interest rate risk?

Interest rate risk is a risk that arises due to fluctuation in interest rates. These interest rate risks control the value of fixed-return assets. Interest rates and the value of investments have an indirect relationship. When interest rates increase, the price of bonds or investments falls. Short-term investments carry lower risk than long-term investments as they have a short maturity period.

Formula for interest rate risk

Interest rate fluctuation affects the investment value or bond value. Thus the interest rate risk is calculated using bond value before fluctuation and value after fluctuation. The equation for calculating interest rate risk is:

$\mathrm{Interest} \mathrm{Rate} \mathrm{Risk} (\mathrm{IRR}) =\frac{\mathrm{Original} \mathrm{Value} \mathrm{of} \mathrm{Bond}-\mathrm{New} \mathrm{Value} \mathrm{of} \mathrm{Bond}}{\mathrm{New} \mathrm{Value} \mathrm{of} \mathrm{Bond}}$

If the interest risk rate is negative, it shows that the interest rate has decreased. If the interest risk rate is positive, it shows that the interest rate has increased.

What is interest rate risk measurement?

Measurement of interest rate risk is an important step in managing interest rate risks. Interest rate fluctuation influences balance sheets and cash flows. Measuring interest-rate risks requires information on the impact of interest rates on balance sheets and cash flows. The gap analysis model, net economic value model, and net interest income model techniques are used in measuring the risk of interest rates.

Gap analysis model

The gap analysis model is used to compute the variation between interest carrying assets and interest-carrying liabilities during the given time. Gap analysis compares interest-earning assets and interest-paying liabilities. Gap analysis is widely used in banking and financial institutions. Banks lend money to individuals and business organizations at a fixed or floating interest rate. Similarly, banks accept funds and investments at fixed or floating interest rates. The interest rates associated with lending and accepting funds are different. The difference between the value of investments and loans is known as the gap. When the gap is positive, it indicates that the entity or bank’s interest-bearing asset is higher than its liabilities and vice versa.

Net economic value model

The net economic value method is utilized to work out interest rate risk. The net economic value method calculates the present value of assets and liabilities based on the cash flows from assets and liabilities. Under this model, cash flows from assets and liabilities are discounted to present value using the interest rate. The difference between the present value of assets and liabilities is the capital of the entity. The net economic value method is used against fluctuations in interest rates because the value of assets and liabilities are affected due to the fluctuations in the market interest rate.

Net interest income model

The net interest income model is used to measure the net interest income earned from the interest-earning assets and interest-bearing liabilities. Interest-earning assets generate interest income, whereas interest payment is made on interest-bearing liabilities. The net interest income model calculates the variance between interest income and interest expenses. The interest rate on assets and liabilities may vary based on investment portfolios, mortgages, and markets. Under this model, a baseline balance sheet is prepared to collate the interest rate changes.

Interest rate risk management

Interest rate risk management involves retaining various maturity periods on bonds and using derivatives. Investors can use various derivatives to minimize interest rate risk from investments and assets. The following are the interest rate risk management methods:

Short-term investments

High-interest rate risks arise during the longer maturity period. Long-term investments carry a high-interest rate and interest rate fluctuation affects the value of investments. Under short-term investments, the probability of interest rate fluctuations is lower. Investors tend to hold the short-term investments till maturity pertaining to the lower interest rate fluctuations. Thus, due to the lower probability of interest rate fluctuation, short-term investments have a lower risk.

Sale of long-term investments or bonds

To manage interest rate risk, investors often sell long-term investments and re-invest into high-return investments. The influence of interest rate risks in long-term investments is higher due to high duration. Investors should sell their long-term bonds only after analyzing risks associated with interest rates. In this way, investors can avoid risks and by re-investing they can gain higher income.

Buying floating rate investments

Float rate bonds represent the fluctuation in interest rates in the market. The interest rate of float rate bonds hikes and diminish as per the fluctuations in the market. So the interest rate risk associated with floating-rate investments is lower than fixed-rate investments as the floating rate changes based on changes in the market. Balanced diversification into long-term and short-term floating rate investments reduces the risk and increases the likelihood of higher returns.

Hedging

Hedging is a widely utilized method in interest rate risk management. Investors can follow hedging to avoid interest rate risk and fix a favorable interest rate. Derivatives are used to hedge against interest rate risk and losses. The hedging strategies are forwards, swaps, and futures.

(a) Forward contracts

A forward contract is an agreement of obtaining or exchanging the particular asset on a mentioned future date at a specified rate. Forward contracts are derivatives. It is utilized by players to restrict the risk of interest rate fluctuations. Forward contracts are utilized to fix specific rates on the date of agreement to safeguard from interest floating risks.

(b) Interest rate swaps

Interest rate swaps are derivative contracts that involve the exchange of interest rates between two agencies. Interest rate swaps allow two parties to interchange their interest rates from fixed to floating or floating to fixed. It helps to reduce movement in interest rates. In this swap contract, if one party is receiving fixed interest payment whereas one party receives floating interest payment, then both the parties can agree on exchanging their interest payments till a specified time in the future if they are willing to exchange from fixed-to-floating and floating-to fixed interest payments.

(c) Futures

A futures contract is an arrangement between two agencies that allows one agent to acquire an asset, financial instruments, securities, currencies, and a counterparty to trade an asset, financial instrument, securities, and currencies at a specified future date and at a predetermined rate. Futures have less liquidity than forwarding contracts.

Context and Applications

This topic is significant in the professional exams for both undergraduate courses & postgraduate courses and competitive exams, especially for

• Bachelors of Business Administration (Finance and Banking)
• Bachelors in Risk Management
• Masters in Risk Management
• Masters of Business Administration (Finance and Banking)

Practice Problems

Question 1: Interest rate risk is a risk which arises due to fluctuation in ___________.

1. Value of investments
2. Interest rates
3. Duration

Answer: Option (b) is correct.

Explanation: Interest rate risk is a risk that arises due to fluctuation in interest rates. Interest rate risks are largely linked to the value of fixed-rate long-term bonds. Interest rate risk and investment value have an inverse relationship.

Question 2: What are the derivatives used in interest rate hedging?

1. Interest rate swaps
2. Forwards
3. All of the above

Answer: Option (c) is correct.

Explanation: Interest rate swaps and forwards are utilized to mitigate the risk of interest rate. Interest rate swaps involve exchanging of interest rates between two parties. Forward contracts are utilized by players to restrict the risk of interest rates. Forward contracts should be used to fix specific interest rates on the date of agreement to keep away from the interest rate floating risks.

Question 3: Which is the interest rate risk measuring technique?

1.  Futures
2. Net economic value model
3. None of the above

Answer: Option (b) is correct.

Explanation: Net economic value model is one of the interest rate risk measurement techniques. The net economic value method calculates the present value of assets and liabilities based on the cash flows from assets and liabilities. Under this model, cash flows on assets and liabilities are discounted to present value using the interest rate.

Question 4: What are the risk management methods?

1. Short-term investments
2. Sale of long-term investments
3. All of the above

Answer: Option (c) is correct.

Explanation: Under short-term investments, the probability of interest rate fluctuations is lower in a short duration. The influence of interest rate risks in long-term investments is higher due to high duration. Investors should sell their long-term bonds after analyzing risks associated with interest rates.

Question 5: The_____________________model measuring the variation between interest earning assets and interest bearing liabilities.

1. Net economic value model
2. Net interest income model
3. Gap analysis model

 Answer: Option (c) is correct.

Explanation: The gap analysis method is utilized to work out interest rate risk or liquidity risk. Gap analysis compares interest-earning assets and interest-paying liabilities. This method determines the variation between interest-bearing assets and interest-paying liabilities. This difference is known as the gap.