Interest Rate Risk
Interest rate risk is the risk that arises to financial institutions when investments, assets and liabilities are subject to changing interest rates. The risk is particularly important to institutions who deal with mortgage-backed assets, derivatives and other debt instruments, because changes in interest rates affect the value of these assets. Financial institutions may find themselves liable if they suffer losses due to interest rate changes.
Interest rate risk arises because interest rates are not constant. They move up or down in response to economic and political events and the movement of these rates tends to affect the prices of assets and liabilities based on interest rate levels. For example, when interest rates rise, the value of investments, assets and liabilities linked to those rates go down. On the other hand, when interest rates decline, the value of investments, assets and liabilities goes up.
Interest rate risk affects all types of financial institutions and these effects can range from minor losses to complete financial failure. With the advent of new technologies, the amounts of risk imposed by interest rates have increased significantly. Institutions can use derivative instruments, such as futures, options and swaps to manage their exposure to interest rate risk. These instruments are used to lock in an interest rate level, allowing institutions to protect themselves from losses caused by changes in the rates.
When interest rate risk increases, so do costs to the financial institution. Losses associated with interest rate risk can force institutions to close or downsize. Institutions would be wise to employ analysts and computer models to monitor and identify changes in interest rates and the resulting effects on their portfolios. Risk management practices, such as diversification, stress testing and hedging, can reduce a financial institution’s vulnerability to interest rate risk.
Interest rate risk can also have an impact on the overall economy. Economic slowdowns and recessions are often linked to instability in the interest rates, which can lead to downturns in the stock market. As a result, financial institutions are often forced to increase their lending costs and/or reduce their profit margins. This in turn can lead to an overall decrease in economic activity.
Interest rate risk is a very real and unavoidable risk for all financial institutions. Although there are methods to reduce the impact of interest rate risk, it is important to focus on risk management practices to minimize the effects of interest rate risk. Institutions may also consider hedging strategies to manage their exposure to interest rate risk and hopefully minimize their losses in the event of a shift in rates.
