Unit
- Repricing risk: This risk arises when assets and liabilities reprice at different times or at different rates, causing net interest income to fluctuate. For example, a bank that holds long-term fixed-rate loans funded by short-term deposits faces repricing risk if rates rise.
- Yield curve risk: Changes in the shape of the yield curve affect the relative value of assets and liabilities. A flattening or steepening of the curve can impact earnings and economic value, even if the overall level of rates remains unchanged.
- Basis risk: This occurs when the repricing of assets and liabilities is based on different reference rates. For instance, an asset tied to LIBOR and a liability tied to Treasury rates may not move proportionately, leading to margin compression.
- Optionality risk: Embedded options in financial instruments, such as prepayment options on mortgages or early withdrawal privileges on deposits, create uncertainty in cash flows. When interest rates change, borrowers may prepay or depositors may withdraw, altering the expected duration.
- Reinvestment risk: When cash flows from assets are reinvested at lower rates than the original yield, future income declines. This is particularly relevant for fixed-income portfolios with periodic coupon payments in a falling rate environment.
- Funding risk: The risk that a financial institution cannot secure funding at reasonable rates to support its asset base. A sudden increase in rates may raise funding costs and squeeze net interest margins.
- Gap risk: Mismatches in the timing of cash flows between assets and liabilities expose the institution to changes in interest rates. A positive gap (assets repricing faster than liabilities) benefits from rising rates, while a negative gap benefits from falling rates.
- Economic value risk: The present value of future cash flows from assets minus liabilities changes as rates move. This economic value perspective complements the earnings view and is essential for long-term solvency analysis.
- Duration gap risk: The mismatch between the modified duration of assets and liabilities determines the sensitivity of equity value to interest rate shifts. A positive duration gap (assets longer than liabilities) exposes the firm to rising rates, while a negative gap benefits from rate declines. Duration analysis helps quantify this exposure for hedging and capital planning.
- Convexity risk: When the relationship between bond prices and yields is nonlinear, large interest rate changes cause duration-based estimates to deviate significantly. Instruments with negative convexity, such as mortgage-backed securities, experience greater price declines when rates fall due to prepayment acceleration, increasing economic value risk.
- Net interest income sensitivity: This measures the change in net interest income under different rate scenarios. Banks simulate parallel and nonparallel shifts, as well as changes in slope and volatility, to estimate potential earnings volatility. Such analysis informs the setting of interest rate risk limits and the design of hedging strategies.
Risk Assessment
HIGH RISK
Interest rate risk is classified as high for most financial institutions due to the magnitude of potential earnings and capital impact. For example, a 200 basis point parallel shift in rates can reduce the economic value of equity for a typical bank by 15 to 25 percent, requiring active management and regulatory capital buffers.
Quick Revision
- Interest rate risk arises from mismatches in repricing, yield curve movements, basis differences, and embedded options.
- Repricing risk is the most common source, linked to timing mismatches between asset and liability rate resets.
- Yield curve risk affects relative asset-liability values when the curve shifts non-parallel.
- Basis risk emerges when different reference rates do not move in tandem.
- Optionality risk introduces cash flow uncertainty due to borrower or depositor behavior.