Interest rate risk is a form of market risk. Interest rates risk states that the relational or proportional value of an interest rate security. (for example, bond or loan) Will decrease due to an increase in the interest rate. In general, if interest rates rise, the price or value of a bond with fixed interest rates will decrease and vice versa.
Interest Rate Risk
Interest rate risk measurement is generally done with the help of the bond and is the earliest. Of the countless methods applied against interest rate. One of the basic techniques applied for the management of interest risk is asset liability management. This technique includes a comprehensive collection of methods used in a common organizational risk management infrastructure.
Calculation of Interest
Analysis of interests rate is often done on the basis of imitating changes in a range of return curves. (risk-free arbitrage) Ensure that yield curve changes are the same as current market return curves.
There are many standard calculation methods, consisting of different types of assets and liabilities. That are used to measure the effect of variable interest rates on a portfolio.
The most basic methods are:
1) Calculation of the net market value of liabilities and assets. In some cases, it is called the market value of portfolio equity.
2) Conducting a stress test of this market value with the help of a certain shift in the yield curve. Time is somehow a form of stress test, in which case the shift of the yield curve is parallel.
3) Calculation of the value at risk in the portfolio.
4) Calculation of financial income and expenses or cash flows accumulated in more than one period in N in a settled collection of future return curves.
5) The fifth step involves the implementation of step 4 with the measurement of return curve. Shifts that are stochastic in nature and the measurement of cash flow probability distributions and accumulated financial gains during the passage of time.
6) Measuring the difference between interest sensitivity of assets and liabilities by categorizing the maturity and interest rates of assets and liabilities according to the timing, whichever occurs first.
Interest Rate and Banks
There are four types of interest rate risks that banks face:
1- Return curve risk: It is expressed in case of deviations or differences between long-term and short-term interest rates.
2- Basic risk: This risk arises when the expenditures for returns and debts from assets are determined in comparison with the proposed rate between banks.
3- Option risk: This risk is exhibited with the help of the options included in a number of assets and liabilities.
4- Repetition risk: This risk is demonstrated by liabilities and assets where repricing is done at various rates and times.
Hedging from interest rates risk can be done through fixed rate interests rate swaps or financial instruments. Interest rates risk can be minimized through short-term bond purchases or participation in a fixed variable interests rate swap.