Interest rate risk
Category: Bank Management
Definition
This kind of risk is the core of the banking business which consists in granting a loan from collected funds. The interest rate risk anises when the cost of the resources is higher than the interest obtained from the loans.
Interest rate risk is present all through the life of a credit unless the durations of the resources and the loans match one another perfectly. Even then, the risk can appear if the borrowers or the depositors ask to reimburse or to be reimbursed in advance, because the original match disappears.
This risk originates from:
— trying to match fixed rate resources (or loans) with variable rate loans (resources)
— a difference between the duration of fixed resources and loans
Measure exchange rate risk
A profile of maturities has to be drawn up for assets and liabilities with a fixed rate; this gives the base rate of the bank.
A short position happens to be when there is an excess of fixed rate liability compared to the corresponding asset.
This is favourable in case of rising interest rate.
This is unfavourable in case of falling interest rate.
A long position comes from an excess of fixed rate assets compared to the corresponding liability.
This is favourable in case of falling interest rate.
This in unfavourable in case of rising interest rate.
Interest rate position
With a profile of maturities, the treasurer can measure the incidence of the variation of the interest rate. Different methods exist such as duration or net discounted value systems.
Managing the interest rate risk
Two different methods can be used:
in the long term, banks will adapt the rates (fixed or revisable) and/or the maturities of its assets and liabilities to get to a suitable position to meet the risk level decided by Management; banks try to cancel the exposure as much as possible.
A second method consists in covering, at a later date, an identified risk by using derivative instruments; banks get an inverse position so that the result is null.
It cannot be systematic as it cancels the profits and depends mostly on anticipation made by operations.