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INTEREST RATE RISK

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 driven by interest rates. Since interest rates are unstable, so are earnings.

Anyone who lends or borrows is subject to interest rate risk. This is obvious for borrowers and lenders with a variable rate. But loans and debts that are on fixed rates are also subject to interest rate risk because fixed rate lenders could lend at higher than their fixed rate if rates increase and borrowers could pay a lower interest rate when rates decline. Fixed rate transactions are not exempt of interest rate risk because of the opportunity cost that arises from market movements.

Implicit or explicit options embedded in banking products are another source of interest rate risk. A well-known case is that of the re-negotiation of loan interest rates that can y a fixed rate. The borrower can always repay the loan or borrow at a new rate, a right that he or she will exercise when interest rates decline substantially. Variable rate loans can embed an explicit cap in the interest rates, in which case, the option is explicit. Several loans embed a grace period, such as sub-prime loans beyond which rate hikes occur.

Deposits carry options as well, since deposit holders transfer funds to term deposits earning interest revenues when interest rates increase. Optional risks are "indirect" interest rate risks because they do not depend only from changes of interest rates but also result from the behavior of customers. Notably, prepayment risk depends on geographical mobility or other factors unrelated to interest rates.

 
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