Interest rate risk

What is the Interest Rate Risk?

Interest rate risk is the chance that an unexpected change in interest rates will negatively affect the value of an investment.

Interest rate risk is the probability that the market interest rates will rise significantly higher than the interest rate earned on investments such as bonds, resulting in their lower market value. This risk is higher on long-term bonds.

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 the shape of the yield curve, or in any other interest rate relationship. Such changes usually affect securities inversely and can be reduced by diversifying (investing in fixed-income securities with different durations) or hedging (such as through an interest rate swap).

Interest Rate Risk is the risk of loss due to a change in interest rates. Interest rate risk is important to transactions like interest rate swaps. In such a transaction, the party receiving the floating rate will receive a smaller amount should the floating rate decrease. Interest rate risk is also important to bonds; if interest rates rise, the prices of bonds fall. This affects the secondary market for bonds; for example, if one purchases a bond with a 3% interest rate and the prevailing rate rises to 5%, it becomes difficult or impossible to resell the bond at a profit. Finally, interest rate risk is important to project finance. If interest rates rise, funding may not be available for a new loan for a project that has already started.

Interest Rate Risk is the risk that interest rates will rise and reduce the market value of an investment. Long-term fixed-income securities, such as bonds and preferred stock, subject their owners to the greatest amount of interest rate risk. Short-term securities, such as Treasury bills, are influenced much less by interest rate movements. Common stock prices are also affected by changes in interest rates, although the linkage is less clear than is the case with debt securities and preferred stock.

The cause of Interest Rate Risk

Risk arises for businesses when they do not know what is going to happen in the future, so obviously there is risk attached to many business decisions and activities. Interest rate risk arises when businesses do not know:

  • how much interest they might have to pay on borrowings, either already made or planned, or;
  • how much interest they might earn on deposits, either already made or planned.

If the business does not know its future interest payments or earnings, then it cannot complete a cash flow forecast accurately. It will have less confidence in its project appraisal decisions because changes in interest rates may alter the weighted average cost of capital and the outcome of net present value calculations.

There is, of course, always a risk that if a business had committed itself to variable rate borrowings when interest rates were low, a rise in interest rates might not be sustainable by the business and then liquidation becomes a possibility.

Note carefully that the primary aim of interest rate risk management (and indeed foreign currency risk management) is not to guarantee a business the best possible outcome, such as the lowest interest rate it would ever have to pay. The primary aim is to limit the uncertainty for the business so that it can plan with greater confidence.

Various economic forces affect the level and direction of interest rates in the economy. Interest rates typically climb when the economy is growing, and fall during economic downturns. Similarly, rising inflation leads to rising interest rates (although at some point, higher rates themselves become contributors to higher inflation), and moderating inflation leads to lower interest rates. Inflation is one of the most influential forces on interest rates.

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 10-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

In general, short-term bonds carry less interest rate risk; less responsive to unexpected interest rate changes than long-term bonds are. This implies that short-term bonds carry less interest rate risk than long-term bonds, and some financial theorists cite this as support for a popular hypothesis that the higher yields of long-term bonds include a premium for interest rate risk.

It is interesting to note that bond investors who intend to hold their bonds to maturity are less exposed to interest rate risk for two reasons. First, these investors are not interested in interim price movements because they intend to hold the bond until it matures. Second, the amount of principal the investor receives at maturity is unaffected by changes in interest rates. However, the buy-and-hold bond investor is still exposed to the risk that interest rates will rise above the bond’s coupon rate, therefore leaving the investor “stuck” with below-market coupon payments.

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 premium, which 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.

Calculating Interest Rate Risk

Interest rate risk analysis is almost always based on simulating movements in one or more yield curves using the Heath-Jarrow-Morton framework to ensure that the yield curve movements are both consistent with current market yield curves and such that no riskless arbitrage is possible. The Heath-Jarrow-Morton framework was developed in the early 1991 by David Heath of Cornell University, Andrew Morton of Lehman Brothers, and Robert A. Jarrow of Kamakura Corporation and Cornell University.

There are a number of standard calculations for measuring the impact of changing interest rates on a portfolio consisting of various assets and liabilities. The most common techniques include:

  1. Marking to market, calculating the net market value of the assets and liabilities, sometimes called the “market value of portfolio equity”.
  2. Stress testing this market value by shifting the yield curve in a specific way.
  3. Calculating the value at risk of the portfolio/
  4. Calculating the multiperiod cash flow or financial accrual income and expense for N periods forward in a deterministic set of future yield curves.
  5. Doing step 4 with random yield curve movements and measuring the probability distribution of cash flows and financial accrual income over time.
  6. Measuring the mismatch of the interest sensitivity gap of assets and liabilities, by classifying each asset and liability by the timing of interest rate reset or maturity, whichever comes first.
  7. Analyzing Duration, Convexity, DV01 and Key Rate Duration.

Interest rate risk at banks

The assessment of interest rate risk is a very large topic at banks, thrifts, saving and loans, credit unions, and other finance companies, and among their regulators. The widely deployed CAMELS rating system assesses a financial institution’s: (C)apital adequacy, (A)ssets, (M)anagement Capability, (E)arnings, (L)iquidity, and (S)ensitivity to market risk. A large portion of the (S)ensitivity in CAMELS is interest rate risk. Much of what is known about assessing interest rate risk has been developed by the interaction of financial institutions with their regulators since the 1990s. Interest rate risk is unquestionably the largest part of the (S)ensitivity analysis in the CAMELS system for most banking institutions. When a bank receives a bad CAMELS rating equity holders, bond holders and creditors are at risk of loss, senior managers can lose their jobs and the firms are put on the FDIC problem bank list.

See the (S)ensitivity section of the CAMELS rating system for a substantial list of links to documents and examiner manuals, issued by financial regulators, that cover many issues in the analysis of interest rate risk.

In addition to being subject to the CAMELS system, the largest banks are often subject to prescribed stress testing. The assessment of interest rate risk is typically informed by some type of stress testing.