Interest rate risk in Global Market Analysis

Interest rate risk is the risk that arises for bond owners from fluctuating interest rates.

How much interest rate risk a bond has depends on how sensitive its price is to
interest rate changes in the market. The sensitivity depends on two things, the bond's
time to maturity, and the coupon rate of the bond.

Calculation
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.

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: Capital
adequacy, Assets, Management Capability, Earnings, Liquidity, and Sensitivity to
market risk. A large portion of the Sensitivity 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 sensitivity 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 Sensitivity 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. 

Like other investments, when you invest in bonds and bond funds, you face the risk
that you might lose money. Here are some common risk factors to be aware of with
respect to bond and bond fund investments.

Interest Rate Risk

Remember the cardinal rule of bonds: When interest rates fall, bond prices rise, and
when interest rates rise, bond prices fall. Interest rate risk is the risk that changes in
interest rates (in the U.S. or other world markets) may reduce (or increase) the market
value of a bond you hold. Interest rate risk—also referred to as market risk—
increases the longer you hold a bond.

Let's look at the risks inherent in rising interest rates.

Say you bought a 10-year, $1,000 bond today at a coupon rate of 4 percent, and
interest rates rise to 6 percent.

If you need to sell your 4 percent bond prior to maturity you must compete with
newer bonds carrying higher coupon rates. These higher coupon rate bonds decrease
the appetite for older bonds that pay lower interest. This decreased demand depresses
the price of older bonds in the secondary market, which would translate into you
receiving a lower price for your bond if you need to sell it. In fact, you may have to
sell your bond for less than you paid for it. This is why interest rate risk is also
referred to as market risk.

Rising interest rates also make new bonds more attractive (because they earn a higher
coupon rate). This results in what's known as opportunity risk—the risk that a better
opportunity will come around that you may be unable to act upon. The longer the term
of your bond, the greater the chance that a more attractive investment opportunity will
become available, or that any number of other factors may occur that negatively
impact your investment. This also is referred to as holding-period risk—the risk that
not only a better opportunity might be missed, but that something may happen during
the time you hold a bond to negatively affect your investment.

Bond fund managers face the same risks as individual bondholders. When interest
rates rise—especially when they go up sharply in a short period of time—the value of
the fund's existing bonds drops, which can put a drag on overall fund performance.
Interest Rate Risk Management
The last few years have witnessed exceptional volatility in interest rates.
This has resulted in the creation of an additional concern for financial
managers, “interest rate risk." Uncertainty about the future cost of a firm’s
debt, from the stockholder’s point of view, is a source of risk. Uncertainty
increases when unanticipated movements in interest rates result in a potential
loss (or gain) because of the mismatch existing between the maturity of the
debts (liabilities) and of the assets which they are financing.

Traditionally this problem was solved by matching the maturity of debts and
the life span of the assets they were financing. However, due to relatively high
and uncertain inflation which started in the late 1960’s, the long-run cost of
debt become uncertain. As pointed out by Putnam (1983), this is mainly
because of the strong correlation that exists, over the long-run, between
changes in the inflation rate and movements in interest rates. That is, if
inflation were known with certainty by both lenders and borrowers, then by
adding an inflation premium the long-term interest rates could be kept
relatively constant.

In practice, however, changes in inflation are not known with certainty.

Therefore, the first step in managing the firm’s interest rate is to assess its
long-term exposure to changes in the rate of inflation.

One way to deal with the high inflation uncertainty has been the use of flexible
interest loans (floating rate) on which the interest rate may be reset every six
months or may be based on short term interest rates. The main drawback of
floating rate loans is that the short-term interest rate may change as a result of
real interest rate (nominal interest rate minus inflation rate) changes in the
economy. This means a higher real interest cost for the borrower, because the
cost of the firm’s inputs will increase, while the price of the firm’s outputs will
stay constant.
Managing Interest Rate Risk
As discussed earlier, one way to manage interest rate risk emanating from high
inflation uncertainty is the use of roll-over credits and floating rate loans on
which the interest rate may be reset every six months or so based on short-term
interest rates. On the other hand, if the short-term interest rate fluctuations
depend on economical factors such as fiscal policy, savings propensity, or the
level of aggregate investment, then the long-term loans are more favorable
from the risk point of view.

Interest rate risk, whether its source is changes in rate of inflation or real
interest rate movements, can be diversified by creating an international debt
portfolio. That is, issuing debt or bond denominated in currency baskets such
as European Currency Unit (ECU) or Special Drawing Right (SDR). However,
if the inflation rates underlying the different basket-currencies’ values are very
similar, then there is little value in this diversification (Oxelheim, 1981).

An alternative approach to the above mentioned practices of interest risk

management is the hedging instrument offered by the futures markets, i.e., the
financial futures contracts. Financial futures contracts are perhaps the most
common hedging tool used against interest rate swings.

Over the last few years, the dynamic evolution in the development of the
market in options and swaps, together with the growth of the forwards and
futures markets, has provided financial managers with new tools for managing
interest rate and exchange rate risks. These so called “off-balance-sheet
instruments” are now available in most European countries,7 and firms can use
them for hedging their positions against changes in the interest rates swings.
Summary and Conclusion
Over the last few years, changes in the international financial system have
resulted in an increasing volatility of currency and interest rates. Fluctuations
in the exchange rate and movements in the interest rates are linked to each
other through some basic relations observed in the international financial
markets. The emergence of a global market, together with the rapid
integration of the international financial markets, has increased the adverse
effects of these fluctuations on the firms’ performance throughout the world.
There are two major types of exchange rate exposure; first, accounting
exposure, and second, economic exposure. The latter can be divided further
into transaction exposure and strategic exposure. We have reviewed several
methods of measuring the exchange rate economic exposure as well as the
interest rate exposure.

It was noted that measurement models suggested in the finance literature share
a common drawback; they do not analyze the effects of fluctuations in the
currency and interest rates in the context of the firm’s competitive position.
Therefore, a comprehensive measurement model was suggested, which takes
into account the effects of changes in currency and interest rates on the firm’s
competitive position.