November 25, 2012

MA0042 [Treasury Management] Set2 Q4

Q.4 Explain various sources of interest rate risk.

Ans:  

The interest rate risk adversely affects the organisations financial situation. It poses significant threat to the incomes and capital investments of the organisation. The changes occurring in interest rate affects the value of underlying assets of the organisation. It changes the price values of interest bearing asset and liability based on the magnitude level of fluctuations in interest rates. We shall discuss some of the sources of interest rate risk in the following subsections.

Yield curve risk
The yield refers to the relationship between short term and long term interest rates. The yield curve risk occurs due to the yield curve fluctuations which affect the organisations income and economic values of underlying assets. The short term interest rates are lower than long term interest rates and hence the occurring fluctuation exposes the organisation to maturity gap of interest rate risk. The variations in movements of interest rates changes when the yield curve of a market flattens or steepens in the interest rate cycle.

The yield curve slopes upwards when the short term interest rates are lower than the long term interest rates. This yield curve is known as normal yield curve. The yield curve flattens when the short term interest rates increases across the long term interest rates. This occurs during the transition of the normal yield curve to an inverted curve. It is called as flat curve. The inverted yield curve refers to the economic recession period. Therefore the market status overviews the yield curve of long term interest rate as decline in the long term fixed income of the organisation. The effects of recession impose negative impacts to the organisation hence they must concentrate on diversifying the investment portfolio.

Figure 1 depicts the normal yield curve
Figure 1: Normal Yield Curve

Figure 2 depicts the inverted yield curve
Figure 2: Inverted Yield Curve

The yield curve has major impacts on the consumers, equity and fixed income investors. The fixed rate loans will be encouraged when the short term rates exceeds the long term rates. Hence the consumers who invest in financing properties experience higher mortgage payments. The fixed income investors are benefited with better returns with short term investments due to the elimination of risk premium for long term investments. During the phase of inverted yield curve the margins of the profits decline such that the organisation at short term rates borrow cash and lend it at long term rates to gain profits.

Basis risk
Basis risk occurs due to the changes in relationship between the various financial markets or financial instruments. The different market rates of financial instruments differ with time and amounts. In the banking organisation basis risk occurs due to the differences in the prime rate and offering rates on money market deposits, saving accounts. The changes of interest rates can give rise to unexpected changes of asset and liability cash flows and earnings. For example - an organisation holds large untraded stocks. If the company tries to sell those stocks in wholesale, it experiences liquidity risk because the selling prices may be depressed in the market. Hence to overcome this issue, the company enters into futures contract with stock index. This reduces the liquidity risk but increases the basis risk due to the differences between the selling and stock index prices.

The basis risk affects the profits of an organisation by striking the cash positions. The basis risk changes the storable commodities based on the changes of the storage costs over a period of time.

Optionality risk
Optionality risk arises with various option instruments of banks like assets, liabilities. It occurs during the process of altering the banks instruments levels of cash flows by banks customers or by bank itself. The option allows the option holder to buy or sell financial instruments. It usually results in a risk or rewards to the bank. The option holder experiences limited downside risk (paid amount) and unlimited upside reward whereas the option seller has unlimited risk and limited upside reward.

The bank faces losses during the sold position option to its customers. There are chances of losses in banks capital value due to unfavourable interest rate movements such that it exceeds the profits that a bank gains, during the favourable movements. Therefor it has more downside exposure than upside reward.

The options are traded in banks with stand-alone instruments such as over the counter (OTC), exchange traded options, bond loans and so on. The stand-alone instruments are explicitly priced and are not linked with other bank products. Most of the banking organisations allow prepayment option of commercial loans which includes the prepayment process without any penalties. Hence during the decline of rates the customers will perform prepaying loan process which shortens the banks asset maturities while the bank desires to extend it.

Repricing risk
Repricing risk arises due to the differences between the timing of rate changes and cash flows occurring in pricing and maturity of banks instruments such as assets, liabilities and off balance sheets. It is measured by comparing the liability volume with asset volume that reprice within specified period of time. The repricing risk increases the earnings of the banks. Liability sensitivity occurs in banking organisations since repricing asset maturities are longer than the repricing liability maturities. The income of the liability sensitive bank increases during the fall of interest rates and declines when the interest rate increases. Inversely, the asset sensitive bank benefits from rise in rates and detriments with fall in rates.

Repricing risk affects the banks earnings performance. Since the banks focus on short term repricing imbalances are initiated to implement increase interest rate risk by extending maturities to improve profits. The banking organisations must consider long term imbalances during the repricing risk evaluation. If the gauging of long term repricing is improper, there are chances of bank experiencing variations in interest rate movements of future earnings.

Embedded option risk
The embedded option refers to other option securities such as bonds, financial instruments. The embedded option is a part of another instrument which cannot be separated. The callable embedded option bond consists of hold (option free bond) option and embedded call option. The value of the bond changes according to the changes occurring in interest rates of embedded options values. The price of callable bond is equal to the price of hold option bond minus price of call option bond. The decline in interest rates increases the callable option price bond.

Figure 3 depicts the value of embedded call option varying with respect to changes in interest rates.
Figure 3: Value of Embedded Call Option

The embedded putable bond consists of option free bond and embedded put option. The price of putable bond is equal to price of option bond plus price of embedded put option.

Figure 4 depicts the value of embedded put option which is obtained by the changes in interest rates.
Figure 4: Value of Embedded Put Option

The organisations must handle the options effectively such that the various types of bonds under embedded option are exposed to low level of risks. During the selling process of financial instruments there are chances of exposure to significant risks since the holding options are explicit and embedded which provides advantage to holder and disadvantage to seller. The exceeding number of options can implicate leverage magnifying the positive or negative influences of financial options positions in the organisation.

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