Interest rate risk is the
In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty
Uncertainty refers to Epistemology, epistemic situations involving imperfect or unknown information. It applies to predictions of future events, to ...
that arises for
Bond or bonds may refer to:
* Bond (finance)
Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of ...
owners from fluctuating
An interest rate is the amount of interest
Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investm ...
s. 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.
Interest rate risk analysis is almost always based on simulating movements in one or more
Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money avai ...
s 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
Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods ...
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:
# Marking to market, calculating the net market value of the assets and liabilities, sometimes called the "market value of portfolio equity"
# Stress testing this market value by shifting the yield curve in a specific way.
# Calculating the
value at risk
Value at risk (VaR) is a measure of the risk of loss for investments. It estimates how much a set of investments might lose (with a given probability), given normal market conditions, in a set time period such as a day. VaR is typically used by fi ...
of the portfolio
# Calculating the multiperiod cash flow or financial accrual income and expense for N periods forward in a deterministic set of future yield curves
# Doing step 4 with random yield curve movements and measuring the probability distribution of cash flows and financial accrual income over time.
# 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.
Duration may refer to:
* The amount of Time#Terminology, time elapsed between two events
* Duration (music) – an amount of time or a particular time interval, often cited as one of the fundamental aspects of music
* Duration (philosophy) – a th ...
, Convexity, DV01 and Key Rate Duration.
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
The CELS ratings or Camels rating is a supervisory rating system originally developed in the U.S. to classify a bank's overall condition. It is applied to every bank and credit union in the U.S. (approximately 300 institutions) and is also implemen ...
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
Sensitivity may refer to:
Science and technology Biology and medicine
* Sensitivity (physiology), the ability of an organism or organ to respond to external stimuli
** Sensory processing sensitivity in humans
* Sensitivity and specificity, statist ...
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. See:
Stress test (financial)
A stress test, in financial terminology, is an analysis or simulation designed to determine the ability of a given financial instrument or financial institution to deal with an economic crisis. Instead of doing financial projection on a "best e ...
List of bank stress tests:''This list covers formal bank stress testing programs, as implemented by major regulators worldwide. It does not cover bank proprietary, internal testing programs.''
A bank stress tests is an analysis of a bank's ability to endure a hypothetical a ...
List of systemically important banks
Certain large bank
A bank is a financial institution that accepts Deposit account, deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectl ...