Managing Interest Rate Risk

Managing Interest Rate Risk

DOI: 10.4018/978-1-5225-7280-0.ch006

Abstract

This chapter discusses the method's application to interest rate risk. The method uses interest rate derivatives elaborating how to value the two-year inverse floater derivative in order to manage interest rate risk. The chapter presents a model for the interest rate risk associated with two-year Inverse Floater Derivative as follows: 1) Monte Carlo simulation is used to stochastically calculate the total Net Present Value (NPV) of the two-year Inverse Floater Derivative, the associated Variance, Standard Deviation and VAR; 2) Six Sigma process capability metrics are also stochastically calculated against desired specified target limits for the total NPV, as well as relating VAR of two-year Inverse Floater Derivative; 3) Simulation results are presented and analysed.
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Introduction

The interest rate risk is the risk of declines of net interest income, or interest revenues minus interest cost, due to the movements of interest rates. Most of the loans and receivables of the balance sheet of banks, and term or saving deposits, generate revenues and costs that are interest rate driven.

Any party who lends or borrows is subject to interest rate risk. Borrowers and lenders at floating rates have interest costs or revenues indexed to short-term market rates. Fixed-rate loans and debts are also subject to interest rate risk. Fixed-rate lenders could lend at higher than their fixed rate if rates increase and fixed-rate borrowers could benefit from lower interest rates when rates decline. Both are exposed to interest rate fluctuations because of their opportunity costs arising from market movements.

An early research by Morrison and Pyle (1978) established that a bank or other financial institution is potentially subject to at least four types of risk: i) Credit risk - defaults or delays in repayments; ii) Fraud - embezzlement or insider abuse; iii) Liquidity risk - or high cost of obtaining needed cash; and iv) Interest rate risk - differential changes in the value of assets and liabilities as interest rates shift. This paper reports a study of the interest-rate elasticity of the net worth of a commercial bank. Most of the study is devoted to the development of the necessary methodology to measure the interest-rate elasticity (IRE) of a bank's asset/liability mix. The paper first summarises the history of interest-rate elasticity models and points out the problems in applying them to bank assets and liabilities. An analytical framework is then developed to calculate the IRE of a portfolio of assets and liabilities. Next, a framework is applied to a simulated bank. For simplicity, the bank is assumed to have only two classes of assets (commercial loans and cash) and three classes of liabilities (demand deposits, large denomination CD's, and capital). Also, the paper develops models of the cash flows associated with each of the assets and liabilities. Moreover, it quantifies the parameters necessary to calculate the net worth and IRE measures. In addition, simulation models and simulation results are presented for the period 1973-75. The paper concludes with a discussion of the regulatory implications of the study.

Grumball (1987) published a book about interest rate risk management. During the late 1980s, new techniques have emerged to improve treasury management, particularly in the area of interest rate risk. This book covers the principles of interest rate management and its accounting, tax, and administrative implications. Particularly valuable explanations are given of the more sophisticated techniques of interest rate swap guarantees, forward rate agreements, and interest rate swap options, with examples of each.

Francis and Wolf (1993) edited a handbook of interest rate risk management. Considering that the risk management products and derivatives have grown ever more numerous and diverse since the late 1980s, investors need to know which ones will best serve their needs in today's dynamic bond market. This book reveals how more than three dozen experts control and preserve the value of their own fixed income portfolios--from choosing the right risk management product to monitoring and evaluating the effectiveness of hedge management strategies. It also shows investors how to make the best use of swaps, options, futures, and other risk management products in the market; identify and measure a portfolio's or corporation's risk exposure.

Lederman, Klein and Cornyn (1997) edited a book discussing interest rate risk management. This book comprehensively covers subjects explaining how to control and manage interest rate risk. The major topics include: i) The Term Structure of Interest Rates; ii) Interest-Rate Risk Measures; iii) The Estimation of the Duration of Non-Maturity Deposits; iv) Financial Engineering as a Solution to Interest-Rate Risk Management Challenges; v) Managing Interest-Rate Risk for Commercial and Savings Institutions, Mortgage Banking Industry, and Credit Card Portfolio; and vi) Interest-Rate Risk Management Strategies.

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