Interest Rate Risk (IRR)


Interest Rate Risk (IRR) is the potential loss from unexpected changes in interest rates which can significantly alter a bank’s profitability and market value of equity. 

Interest rate risk exists in an interest-bearing asset, such as a loan or a bond, due to the possibility of a change in the asset's value resulting from the variability of interest rates. Interest rate risk management has become very important, and assorted instruments have been developed to deal with interest rate risk.

Types of Interest Rate Risk

Credit spread risk in the banking book (CSRBB)  refers more generally to the current or prospective risk to both the bank’s capital and earnings arising from adverse movements in risk-free interest rates, which affect the bank’s banking book exposures. Four main subtypes of IRRBB are defined in the literature:

(a) Gap risk: refers to the most common form of IRRBB and describes the risk arising from the timing of instrument rate changes. Gap risk arises from the term structure of banking book instruments. Since rate resets on different instruments occur at different tenors, the risk to the bank arises when the rate of interest paid on liabilities increases before the rate of interest received on assets does so, or the rate received on assets falls before the rate paid on liabilities does. Unless hedged in terms of tenor and amount, the bank may be exposed to a period of reduced or negative interest margins, or may experience changes in the relative economic values of assets and liabilities. The extent of gap risk depends also on whether changes to the term structure of interest rates occur consistently across the yield curve (parallel gap risk) or differentially by period (non-parallel gap risk).

 (b) Non-parallel gap risk: refers to the risk associated with a change in the relative interest rates of instruments at different tenors, which invalidate hedge ratios between instruments repricing at different maturities. In other words, it represents the risk arising from changes in the slope and the shape of the yield curve as opposed to a parallel shift.

(c) Optionality risk: refers to the risk that arises from price movements in instruments that are either automatic or behavioural to changes in interest rates. This implies a potential non-linear response to a change in interest rates, which is challenging for a financial institution to hedge as it usually requires dynamic adjustments in the hedge ratios. In the banking book context, many instruments with embedded optionalities are difficult to value given their held-tomaturity nature, and the lack of markets that buy and sell equivalent option products or given client behaviours.
(d) Basis risk: refers to the impact of relative changes in interest rates for financial instruments that have: (i) either similar tenors but are priced using different interest rate reference curves (reference rate basis risk); or which have (ii) different tenors but the same reference curve (tenor basis risk or short-term non-parallel gap risk); or which have (iii) similar tenors and reference curves but in different currencies (currency basis risk). All types of basis risk could lead to margin compression and differential EV effects.

Monday, 11th Apr 2016, 12:35:26 AM

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