Watson, 2008 According to the test book, Understanding and Managing Interest Rate Risk, interest rate risk should be managed where fluctuations in interest rate impact on the organization’s profitability. Financial risk should be appropriately managed where the core operations of an organization are something other than financial services, so that the focus of the organization is on providing the core goods or services without exposing the business to financial risks.

In addition, according to the Handbook, Comptroller’s, (Handbook, 1998) IRR is the risk to earning or capital arising from movement of the interest rate. It may arise from between the timing of rate changes and the timing of cash flow. The changing rate relationships may arise from

The yield curves that affect bank activities which is basic risk,

The changing rate relationships across the spectrum of maturities which is yield curve risk, and

Interest rate related options embedded in bank products which are option risk.

So, Section 2.1 that we need to discuss in this report is about the sources and types of IRR such as reprising risk, yield curve risk, basis risk and option risk. This is because most of the corporation which are especially offer bond will face all these risks. However, understanding all the sources of the interest rate risk allows the corporation to come out a risk management plan to face all the risk and help the corporation to minimize the loss from the interest rate risk.

Besides that, as corporations usually finance their businesses either by issuing shares or borrowing loan, therefore, corporation should be acted sensitivity on the change of interest rate. The risk of a corporation can exposes to the future changes of interest rate is called IRR. We strongly believe that IRR should manage well to ensure the liquidity of corporation. So, we will bring the topic ‘Factors that affecting IRR’ into discussion in Section 2.2.

Furthermore, we will discuss few methods that corporation can used it to measure or evaluate to IRR such as duration approach, sensitivity analysis, and full valuation approach in Section 2.3. The evaluation of the IRR must consider the impacts of complex, illiquid hedging strategies and also the potential of the income that is sensitive to change the interest rate. Hence, the corporation or the financial institution can calculated the interest rate from the risk that may occur in future.

Section 2.4 will discuss about the impact of the IRR because it is vital for a company’s sustainability. It can create awareness for a company to mitigate the interest rate risk in order to manage the company’s reported profits properly. High interest rate risk can result in unstable fluctuation and uncertainty in the interest rate. A high fluctuation in interest rate can affect a business in several ways.

Lastly, Section 2.5 will discuss about the management of the IRR. It is important because it can help the corporation to identify all the possible risk and to determine the level of each risk. Besides that, a good IRR management may help the corporation to reduce or minimize the risk to the corporation.

Discussion and Findings

Sources and types of interest rate risk

(Riskglossary.com, 2005) According to the website of Riskglossary, there are many types of interest rate risk which included repricing risk, yield curve risk, basic risk and option risk.

Repricing Risk

Repricing is any occasion which causes interest rates are to be reset which might either because of the maturities or floating rate resets.  Bank as a financial intermediary has facing interest rate risk. The interest rate risk arises from the difference in the timing of maturity (for fixed-rate) and repricing (for floating-rate) of bank assets and liabilities. Repricing mismatches are fundamental to banking business; they can cause a bank’s income fluctuations as interest rates changes. For example, if interest rates increase, a bank that pay their interest for a long-term fixed-rate loan with a short-term deposit might face problem such as decrease in the future income arising and its underlying value. These decrease happened because the cash flows of the loan are fixed but the interest paid it is floating and the amount will increase after the short-term deposit matures.

Yield Curve Risk

Yield curve risk is the risk of probability that the yield curve will shift in the way which will affects the values of securities tied to interest rates. Mismatching of the repricing can cause a change in the slope and shape of the yield curve. When the market conditions change, the yield at each maturity will change as well and this will cause the yield curve to shift up or down. When interest rates in the market change but yields do not change by an equal amount this will causes a non-parallel shift of the yield curve. The bond issued in the portfolio has many different maturities. When interest rates change, the issue bond price in the portfolio will change and the value of the portfolio will change as well. Portfolios exposure to the yield curve shifts (parallel or nonparallel). This exposure risk is called yield curve risk which is the risk of the changing of price of a bond portfolio varies depending on the shape of the yield curve.

When the yield curve shifts, the bond price in the initial yield curve will change in price. If the yield curve is flattens, the yield spread between long- and short-term interest rates is smaller, so the bond price will change. For example, a short-term bond maturing in two years and the yield of two years decreases, the price of this bond will increase.

Basis risk

Basis risk is also called as spread risk. It is one of the important sources of interest rate risk, which arises from a not perfect correlation in the adjustment of the rates earned and paid on different types of instrument. The changes of the interest rate are one instrument relative to another. When interest rates change, it might cause a change in the cash flows spread between assets, liabilities and OBS instruments with same maturities. A portfolio has which has junk bond hedged with short Treasury futures is exposed to basis risk because of the possible changes in the yield spread of junk bonds over treasuries.

Options risk

Options risk is also one of the components of interest rate risk and it is also another component of term structure risk. This is a risk which happened to fixed income options. It is an important source of interest rate risk which arises from the options. An option is an instrument which provides the holder the right, to buy, sell, or in some ways alter the cash flow of a financial contract. Options may be stand-alone or may be embedded with standard instruments. A bond with call or put provision, loans which give rights to borrower to prepay the balance, or other types of non maturity deposit instrument which provide rights to the depositor to take out the fund at anytime without penalties is the example of instrument which emberred with option.

All these option must be managed to prevent the risk of the optionality. The optionality features of the security might have significant risk especially to holders who sell them, since the options held might be exercised to give advantage to the holder and the disadvantage to the seller. Besides, options can magnify the influences of the option positions on the firm financial condition.

Factors That Affecting Interest Rate Risk

All companies that lend or borrow money to run businesses are subject to interest rate risk. They face interest rate risk when interest rate changes, thus affecting the companies’ bottom line. Interest rate risk is significant to be determined as company may lend or borrow to finance its business and this risk may cause the company to close down if not manage properly. Hence, there is a need to study few factors that affecting interest rate risk so that we can implement better interest rate risk management. (Duff, eHow Money, 2011) However, according to the Duff, the factors are as below:

Loan terms

One of the largest determinants of the interest rate risk a company is exposed to is its loan terms. Therefore, having knowledge on the relationship between either fixed rate interest or floating rate interest and the risk that will be exposed when capitalize a company is very crucial. For example, if the business charges fixed interest rate but short term interest rate increases, this benefits the company but harms the bank because the company pays lesser interest and the bank receives lesser interest payments vice versa. There is an argument stated that ‘if you stay floating, you will always a long term pay lower interest rates than if you are fixed.’

Creditability of the company

The credit risk of the company is determined by its debt over equity ratio. If the company interest rate increases, the equity of the company decreases as the company has to pay more on interest. As a result of increasing credit risk, the company has no choice to raise fund by looking on new borrowing which carry higher interest rate. The more the company exposes to debt, the more interest rate risk the company expose to.

Overall economic climate

The entire economic environments also have an impact on the company’s interest rate risk. For example, in times of economic decline or recession, the company may find that it is difficult to borrow money because the interest rate is higher. The uncertainty of cash inflows but increasing cash outflows for higher interest payments may increase the company’s exposure to interest rate risk.

Foreign exchange rates

Another important factor that might affect interest rate risk will be the foreign currency. For example, a US manufacturing company taking credit term on raw material from China where using Yuan (RMB). The debt will become more expensive if US Dollar weakens. The revenues are still coming in term of US Dollar, but the debt is now a larger drag on the bottom line. From the above examples, we must learn how to reduce interest rate risk in the aspect of foreign currency.

Competitive pressure

Competitive pressure is also another factor that we need to study. For better understanding we would like to relate this point to banking industry. Competitive pressure affect the industry’s management of interest rate risk especially competition may be reducing the banking industry’s ability to manage interest rate risk through discretionary pricing of rates on loans and deposits. For example, growing number of bank in the industry has caused the demand on loans or deposits of a bank decreases and the bank may refuse to offer attractive or lower rates. This may in return increase the company’s interest rate risk as the company raises capital through borrowings.

Methods to measure interest rate risk

There are many ways to measure interest rate risk. The measures can range from very simple measures to very complicated measures which are mathematically complex and require significant computing power. There will some simple measures that can be applied and understood by most organization.

Sensitivity analysis

This measure has divided to three types which are simple analysis, advanced analysis and stress test.

Simple analysis

Simple analysis is measurement of the impact of small changes of interest rates on the accounting income or economic value. (Watson, 2008) According to the example given from Understanding and Managing Interest Rate Risk, if currently interest rates increase by 1 per cent, what will be the impact on the accounting income? Usually an organization will calculated on spreadsheets to find out the interest rate.

Advanced analysis

Advanced analysis is measurement of the impact of multiple changes in interest rates and other related variables on the entity’s financial health. (Watson, 2008) For example, if the entity is 60 per cent hedged and interest rates increase by 1 per cent and earnings before interest, tax, depreciation and amortization fall by 11 per cent, what will be the impact on the entity’s interest cover ratio? So the calculation and information may be presented in a tabular form.

Stress test

Stress test is modeling the impact of a large change in interest rates on borrowings or investments in accounting terms or risk outcomes. This type of measurement is frequently used by financial institutions.

Reprising profiles

Reprising profiles mean that graphical representation of the interest reset of assets and liabilities over time. (Ghosh, 2012) According to the Managing Risks in Commercial and Retail Banking, banks need to conduct historical studies of behavioral reprising profiles as well as use their judgment and experience in assigning time buckets to the items of assets and liabilities that do not have definite reprising intervals, like the interest bearing portion of demand deposits and certain other items like time deposits, loans, revolving retail credits, embedded options with put riders, and so on, where actual behavioral maturities vary from contractual maturities.

Moreover, there have 2 approaches to measure the interest rate risk for the fixed income investment. (Wilson, 2010) According to the CFA Level 1 of Study Guide, the approaches included the full valuation approach and the duration or convexity approach.

The Full Valuation Approach

The first approach is the full valuation approach which is to measuring the interest rate risk is to revalue the bond or portfolio for a given interest rate change scenario. This interest rate change can be parallel or non-parallel. It is also referred to as a scenario analysis because full valuation approach involves the way in which your exposure will change as a result of certain interest rate scenarios. (Wilson, 2010) For example, an investor may evaluate the portfolio based on an increase in rates of 50, 100 and 200 basis points. Each bond is valued and then the total value of the portfolio is computed under the various scenarios.

The Duration or Convexity Approach

(Wilson, 2010) This is contrast with the full valuation approach and it just looks at one time parallel move in interest rates using the properties of price volatility. This is because the full valuation approach uses various outcomes to measure the risk of the bond or portfolio, as compared to a one time move for the duration or convexity approach, it bears that the full valuation approach is better suited to measuring interest-rate risk even though it can be very time consuming.

Below are showing 2 scenarios how to compute the interest rate risk exposure. Let’s take an option-free bond with an 8% coupon, ten-year bond with a price of 125. Yield to maturity is 7%.

Scenario 1 is an increase of 50bps that drives the price down to 120 (this is just an estimate). To see the percentage change you take the new price after the yield change and subtract it from the initial price after the change divided by the initial price. 120 — 125 / 125 = -.04 show that 4 % decrease in the price of the bond due to a 50 bps change.

Scenario 2 is an increase of 100 bps that drives the price down to 114. 114 — 125 / 125 = — .088 show that 8.8% decrease in price due to a 100 bps change. Thus, you can use this for any type of scenario concerning a change in yields.

Management and Control of IRR

Interest rate risk can be managed by companies to prevent uncertainty of company’s profit. An effective management can help to reduce the debt amount, minimize tax payment, and to maintain the stability. Below are the methods to mitigate the interest rate risk.

Derivatives

Derivatives product is a type of security used by companies where prices of underlying assets are dependant to it. Derivatives helps companies to hedge the interest rate risk. Hedging is a strategy used by companies to reduce the risk on an investment. It can help to make an investment safe to invest due to the adverse price movement and serves as an offsetting position in related security.

(Investopedia, 2002)According to the Investopedia, there are many types of derivative, such as:

Future contract which enable the investors to sell the stock at a set price, to avoid the fluctuation due to interest rate risk.

Forward contracts are used to make a future transaction in which the price is determined on the initial trade date.

Options offer the companies the right to call or sell a security or other financial asset at an agreed-upon price during the exercise date.

On the other hand, swap is an exchange between two companies where one stream of future interest payments is exchanged for another based on a specified principal amount.

2.4.2 Interest Rate Risk Management

(A. Dhanani, 2005)According to the Interest Rate Risk Management published by CIMA stated that Interest Rate Risk Management is used to control, within the set limit, the impact of changes in interest rates. The factors included in the interest rate risk management are the frequency, volatility and direction of rate changes, the slope of the interest rate yield curve, the size of the interest-sensitive position and the basis for re-pricing at rollover dates. Different types of interest rate risk management will be taken by institutions based on the nature and complexity of their asset and liability structure, interest rate risk positions and risk profile.

The establishment and implementation of sound and prudent interest rate risk policies:

Interest Rate Risk Philosophy

The ability of each institution to assume interest rate risk and to burden the potential losses will be different based in the limit of the other risks such as the liquidity risk, credit risk, foreign exchange risk and investment risk. A trade-off exists between risk and return as the other aspects of financial management. Its objective is to manage the effect of the interest rate changes within self-imposed limits set after cautions consideration of a range of possible interest rate environments. However, it doesn’t need to complete the elimination of exposure to change in interest rates.

Interest Rate Risk Limits

Interest rate risk limits is needed so that they can ensure that the level of interest rate risk exposure does not exceed these limits. It is set based on an institution’s overall risk profile, which reveals factors such as its capability, liquidity, qualities of credit, risk of investment and foreign exchange. Interest rate status should be managed within the ability of an institution to compensate such status when necessary. Besides that, interest rate risk limits are also required to be re-evaluated on a regular time of period to review all the potential changes in interest rate volatility, overall risk philosophy and risk profile of the institution.

Impacts of the IRR

There are few impacts of the IRR that may face by the institutions or corporations. (A. Dhanani, 2005)The following are the impacts are also from the book of “Interest Rate Risk Management”:

Cost of borrowing

First, increase in interest rate risk will cause the cost of borrowing increase. From the perspective of creditors, a higher interest rate risk will increase the interest payment made by the creditors which are charged at a variable rate. For example, a higher interest rate will increase the mortgage payment that paid by the borrowers. Therefore if the interest rate risk increases dramatically, a company with a high debt financing might suffer financial distress due to the company need to pay a higher interest to the lenders.

Interest income

However from the view point of the bank, its reported earnings will be affected by changes in a bank’s net interest income. The interest income of the bank will increase if the assets carrying interest rate is higher than those on liabilities due to the higher interest rate and vice versa. The earning perspective considers how the changes of interest rate will affect a bank’s reported income. For example, the earnings, liquidity and capital will be reduced due to the changes in interest rate. When the interests’ rates rise, creditors are more likely to extend the period of payment of mortgage loan in order to have longer payment period. As a result, fee income and associated economic value arising from mortgage servicing related businesses may increase because long term interest rate tend to be higher than short term interest rate. Short term reported earnings might be decrease due to the declines in the market values of assets when a bank is required to charge such declines directly to current income. This risk is referred to as price risk. Normally banks with large trading activities will have separate methods and limit systems to manage the price risk.

Aggregate Demand

Next, an increase in interest rate risk will bring negative affects to the company’s business. The company that always require frequent borrowing will be affected by the increase of interest rate risk, as the lenders have to renegotiate the term and condition of loan because the lenders are reluctant to purchase the high interest rate bonds due to the disposable income decrease and increase of the fixed cost. Consequently, it will reduce the aggregate demand of economy and cause the price and output decrease.

Product’s price

Thirdly, from the perspective of supplier, they may raise their prices to cover their funding costs. An increase in price may affect on the financial performance of the supplied businesses. The business such as supermarkets may pass the price increase’s burden to their consumers by increasing the product’s price. However, some companies where competition is highly intense such as and the price policy in the industry is already regulated by government such as petroleum industry and household industry, they may not able to do so, because high interest rates may increase both input costs and interest payment on finance, which will encourage customer to postpone their purchase. Moreover, manufacturer of luxury goods such as jewelry manufacturers are more likely sensitive to the fluctuation of the interest rate because they can adjust the price of jewelry goods as they like. So this sensitive sector should be more focus on management of IRR in order to managing their IRR effectively.

Repricing mismatch

Economic Value perspective provides a method to analyzing the changes of impact of interest on the expected cash flows on assets and the impact of changes of interest rate toward the net value of assets of company. It focused on identify risk arising from long-term interest rate gaps. The bankers have to estimate the future cash flow of their financial instrument such as saving or demand deposits. Due to the uncertainty of cash flow and unpredictable maturities, measuring the interest rate risk of these instruments will be harder. As a result in a long term perspective, the net value of the net assets, which after minus the liabilities, will influenced by the uncertain fluctuation of the market interest rate. As the company revaluate their net assets after a certain period for example 5 years, there will be repricing mismatch occur due to the value of net asset exposed to the risk of sensitivity of the interest rate.

Conclusion and Summary

As a conclusion, IRR is might be very risky if the IRR is too high for a corporation or institutions. By the way, we are discussing most important issues in the section 2.1 until section 2.5 which are about the IRR such as the risks may face by the corporation, the factor of the IRR, the methods to measured IRR, managing of the IRR and the consequences of the IRR in this report. However, we have summaries all the report by the following.

Section 2.1 are many sources of IRR which included repricing risk, yield curve risk, basic risk and option risk. Repricing is any occasion which causes interest rates are to be reset which might either because of the maturities or floating rate resets.  When the market conditions change, the yield at each maturity will change as well and this will cause the yield curve to shift up or down. So, the changes might affect the securities value either will make the value increase or decrease.

Basic risk is one of the important sources of interest rate risk, which arises from a not perfect correlation in the adjustment of the rates earned and paid on different types of instruments. When interest rates change, it might cause a change in the cash flows spread between assets, liabilities and OBS instruments with same maturities.

The last risk is the option risk which is a source of interest rate risk which arises from the options. The optionality features of the security might have significant risk especially to someone who sells them, since the options held might be exercised to give advantage to the holder and the disadvantage to the seller.

In addition, section 2.2 stated that IRR is also a bankruptcy risk which may cause the companies to close their businesses down if they cannot manage the risk well. Therefore, it is essential to learn how to reduce the interest rate risk. From the above study, we can conclude that the variables that should be minimized to reduce interest rate risk are loan terms, credit risk, overall economic climate, foreign exchange rates, and competitive pressure.

Furthermore, section 2.3 said that the methods to measure the IRR can range from very simple measures to very complicated measures which are mathematically complex and require significant computing power. The method to measure IRR included sensitivity analysis, repricing profile, the full value approach and the duration approach.

Section 2.4 show that IRR cannot be prevented but it can be managed and reduced to the lowest risk. Derivatives product such as future contracts, forward contracts, options and swaps can be used by companies to hedge the interest rate risk. Furthermore, a proper interest rate risk management policy will help companies to control the volatility of interest rate and to minimize losses from it.

In the last section 2.5 stated that increase in IRR will cause the cost of borrowing increase. Higher IRR will increase the interest payment made by the creditors which are charged at a variable rate and a company with a high debt financing might suffer financial distress due to the company need to pay a higher interest to the lenders. However, the interest income of the bank will increase if the assets carrying interest rate is higher than those on liabilities due to the higher interest rate.

At the same time, price risk will occur and cause the short term reported earnings decrease due to the declines in the market values of assets when a bank is required to charge such declines directly to current income while the aggregate demand of economy will reduce when there is a higher interest rate risk, the lenders are reluctant to purchase the high interest rate bonds and the lenders have to renegotiate the term and condition of loan.

Lastly, the product price may be increase by the supplier to cover their funding costs and it may affect the financial performance of the supplied businesses. Beside, the difficulty of measuring the interest rate risk by using economic perspective may also cause the repricing mismatch occur because many retail bank’s financial instrument have an unpredictable cash flows and maturities. Thus, company must place the aware of the potential impact of high interest risk as a major concern because it will bring many negative effects to the businesses and also economy.