By Zororo Mukungunugwa
INTEREST rate risk can be defined as the risk that goes on with changes in market values of fixed income assets/instruments following some unexpected changes in the interest rates.
Interest rate risk has an impact on the income streams, liquidity and the solvency of an institution, with the financial institutions being at a greater risk. The risk affects both the assets and liabilities.
As most institutions will have some fixed income securities among their assets and liabilities, interest rate risk is often understood as the net change in the value of all fixed income securities held by the institution.
More generally, interest rate risk can also be defined as the exposure of an institution’s financial position to adverse movements in interest rates. Of greater significance is the fact that this risk can be regarded as one of the major sources of profitability and shareholder value and thus taking it on is part of normal banking.
However, excessive interest rate risk exposure can pose a great threat to a bank’s earnings by changing its net interest income. Such changes in interest rates also have an effect on the underlying value of the bank’s assets and liabilities. This is as a result of the fact that the present value of future cash-flows and the cash-flows themselves in some instances, changes when interest rates change.
Accordingly, an effective risk management process that maintains interest rate risk within prudent levels is essential to the safety and soundness of financial institutions.
Repricing risk – this is the risk that arises from timing differences in the maturity (for fixed rate) and repricing (for floating rate) of bank assets and liabilities positions.
While such repricing mismatches are fundamental to the business of banking, they can expose a bank’s income and underlying economic value to unanticipated fluctuations as interest value vary. For instance, a bank that funded a long-term fixed rate loan with a short-term deposit could face a decline in both the future income arising from the position and its underlying value if interest rates increase.
These declines arise because the cash-flows on the loan are fixed over its lifetime while the interest paid on the funding is variable, and may increase after the short-term deposit matures.
To be continued next week
*Zororo Mukungunugwa is the general manager (finance) for Imperial Asset Management Company and can be contacted on firstname.lastname@example.org