By Zororo Mukungugwa
Continued from last week Basis risk – another important source of interest rate risk arises from imperfect correlation in the adjustment of the rates earned and paid
on different instruments with otherwise similar repricing characteristics.
When interest rates change, these difference can give rise to unexpected changes in the cash-flows and earnings spread between assets and liabilities of similar maturities or repricing frequencies;
Options risk – overand above all, an additional and increasingly important source of interest rate risk arises from the options embedded in many banks’ assets and liabilities portfolios.
Generally defined, an option gives the holder the right but not obligation, to buy or sell, or in some cases change the cash-flow of an instrument or financial contract. These options may be either stand-alone instruments such as exchange-traded op-tions and over the counter (OTC) contracts, or they may be embedded within otherwise standard instruments. While banks use exchange traded and OTC options in both trading and non-trading accounts, instruments with embedded options are generally most important in non-trading activities.
These include various types of bonds and notes with call and put provisions, loans that give borrowers the right to prepay balances and various types of non-maturity deposit instruments which give depositors the right to withdraw funds as they wish. If not adequately managed, the asymmetrical payoff characteristics of instruments with option features can pose significant risk particularly to those who sell them, since the options held, both explicit and embedded, are generally exercised to the advantage of the holder and the disadvantage of the seller; and
Yield curve risk – repricing mismatches can also expose a bank to changes in the slope and shape of the yield curve. Yield curve risk arises when unanticipated shifts of the yield curve have adverse effects on a bank’s income or underlying economic value. For instance, the underlying economic value of a long position in 10-year government bonds hedged by a short position in five-year government notes could decline sharply if the yield curve steepens, even if the position is hedged against parallel movements in the yield curve.
Basically the above constitute the four major sources of interest rate risk and next week we will continue with the same subject and pay particular attention to the methods of assessing it. Consideration will be given to the three main perspectives of assessing interest rate risk – earnings, economic value and embedded losses perspectives.
*Zororo Mukungu-nugwa is the general manager (finance) for Imperial Asset Management Company and can be contacted on firstname.lastname@example.org.