Community bank profitability has been under pressure due to increases in nonaccrual loans, credit losses, other-than-temporary impairment OTTI charges, and loan workout expenses. To meet the challenge of generating positive earnings and more suitable returns for their stakeholders, many banks have lengthened asset maturities or increased assets with embedded optionality. These actions serve to increase interest rate risk exposures and, thus, the need for more robust risk management programs.
As interest rates rise, bond prices fall, and vice versa.
The rationale is that as interest rates increase, the opportunity cost of holding a bond decreases, since investors are able to realize greater yields by switching to other investments that reflect the higher interest rate. Market Interest Rates Interest rate risk is most relevant to fixed-income securities whereby a potential increase in market interest rates is a risk to the value of fixed-income securities.
When market interest rates increaseprices on previously issued fixed-income securities as traded in the market decline, since potential investors are now more inclined to buy new securities that offer higher rates.
Only by having lower selling prices can past securities with lower rates become competitive with securities issued after market interest rates have turned higher.
In that case, the investor may have difficulty selling the bond when others enter the market with more attractive rates. Older bonds look less attractive as newly issued bonds carry higher coupon rates as well.
Price Sensitivity The value of existing fixed-income securities with different maturities declines by various degrees when market interest rates rise.
This is referred to as price sensitivity, meaning that prices on securities of certain maturity lengths are more sensitive to increases in market interest rates, resulting in sharper declines in their security values.
For example, suppose there are two fixed-income securities, one maturing in one year and the other in 10 years. When market interest rates rise, holders of the one-year security could quickly reinvest in a higher-rate security after having a lower return for only one year.
Holders of the year security would be stuck with a lower rate for 9 more years, justifying a comparably lower security value than shorter-term securities to attract willing buyers.
The longer a security's maturity, the more its price declines to a given increase in interest rates. Maturity Risk Premium The greater price sensibility of longer-term securities leads to higher interest rate risk for those securities. To compensate investors for taking on more risk, the expected rates of return on longer-term securities are normally higher than on shorter-term securities.
This extra rate of return is called maturity risk premiumwhich is higher with longer years to maturity. Along with other risk premiums, such as default risk premiums and liquidity risk premiums, maturity risk premiums help determine rates offered on securities of different maturities beyond varied credit and liquidity conditions.The interest rate risk is the risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two rates, in .
ppp gopular models in the area of interest rate risk mana gement over the past two decades. 4. Our goal is to understand interest risk management Interest rate risk comes from movements on the term structure of interest rates 5 6 3 4 e ld 2 Yi 0 1 0 5 10 15 Maturity 5.
Interest Rate Risk Modeling: An Overview.
In an interest rate swap, counterparties exchange a stream of fixed-rate payments for a stream of floating-rate payments typically indexed to LIBOR. Duration and convexity are the basic tools for managing the interest rate risk inherent in a bond portfolio. A short-rate model, in the context of interest rate derivatives, is a mathematical model that describes the future evolution of interest rates by describing the future evolution of the short rate, usually written.
1 ADVISORY ON INTEREST RATE RISK MANAGEMENT January 6, The financial regulators. 1.
are issuing this advisory to remind institutions of supervisory expectations regarding sound practices for managing interest rate risk (IRR). The full valuation approach to measuring the interest rate risk is to re-value the bond or portfolio for a given interest-rate change scenario.