IRR Overview Compile

7/30/2019 IRR Overview Compile

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Interest Rate Risk

Overview

Citra Aryani

Dian Agustina

Luna Mantyasih M

Ratna Nugrahaningsih


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What is Interest Rate ?

What causes Interest Rate to

change?

What is Interest Rate Risk

(IRR)?

Where does IRR come from?

Why manage IRR?

How to Assess IRR Exposure?


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What is Interest Rate ? A rate which is charged or paid for the use

of money. An interest rate is often expressedas an annual percentage of the principal.

It is calculated by dividing the amount of

interest by the amount of principal. Interest rates often change as a result of

inflation and Federal Reserve Policies.

For example, if a lender (such as a bank)

charges a customer $90 in a year on a loan of$1000, then the interest rate would be

90/1000 *100% = 9%


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What causes Interest Rate

to change?

Political short-term gain

Deferred consumption

Inflationary expectations Alternative investments

Risks of investment

Liquidity preference Taxes


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Political short-term gain

Lowering interest rates can give the

economy a short-run boost. Under

normal conditions, most economists

think a cut in interest rates will only

give a short term gain in economicactivity that will soon be offset by

inflation. The quick boost can

influence elections. Mosteconomists advocate independent

central banks to limit the influence

of politics on interest rates.


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Deferred consumption

When money is loaned the

lender delays spending the

money on consumption goods.

Since according to time timepreference theory people

prefer goods now to goods

later, in a free market therewill be a positive interest rate.


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Inflationary expectations

Most economies generally

exhibit inflation, meaning a

given amount of money buys

fewer goods in the future thanit will now. The borrower

needs to compensate the

lender for this.


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Alternative investments

The lender has a choice between

using his money in different

investments. If he chooses one,

he forgoes the returns from allthe others. Different

investments effectively

compete for funds.


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Risks of investment

There is always a risk that the

borrower will go bankrupt,

abscond, or otherwise default

on the loan. This means that alender generally charges a risk

premium to ensure that, across

his investments, he iscompensated for those that

fail.


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Liquidity preference

People prefer to have their

resources available in a form

that can immediately be

exchanged, rather than a formthat takes time or money to

realize.


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Taxes

Because some of the gains from

interest may be subject to

taxes, the lender may insist on

a higher rate to make up forthis loss.


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What is Interest Rate Risk (IRR)? Interest rate risk is the risk (variability in value)

borne by an interest-bearing asset, such as a

loan or a bond, due to variability of interestrates. In general, as rates rise, the price of a

fixed rate bond will fall, and vice versa. Interestrate risk is commonly measured by the bond's

duration. (http://en.wikipedia.org/wiki/Interest_rate_risk)

Interest rate risk is The risk that aninvestment's value will change due to a change

in the absolute level of interest rates, in thespread between two rates, in the shape of the

yield curve or in any other interest raterelationship. Such changes usually affect

securities inversely and can be reduced bydiversifying (investing in fixed-income

securities with different durations) or hedging(e.g. through an interest rate swap).

(http://www.investopedia.com/terms/i/interestraterisk.asp)
http://en.wikipedia.org/wiki/Interest_rate_riskhttp://en.wikipedia.org/wiki/Interest_rate_risk


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What is Interest Rate Risk (IRR)?Accounting Terms

Possibility that the value of an

asset will change adversely as

interest rates change.

For example, when market interestrates rise, fixed-income bond

prices fall.

http://www.allbusiness.com/glossaries/interest-rate-

risk/4943665-1.html
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Insurance Terms

Investment risk associated with the

possibility that there is a rise in the interest

rates after a fixed income security has been

purchased resulting in a decline in thatsecurity's price.

The longer the maturity date of that security,

the greater the exposure of the security'sprice to interest rate fluctuations.

http://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.html

What is Interest Rate Risk (IRR)?
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Banking Terms

Risk that an interest-earning asset,such as a bank loan, will decline in

value as interest rates change.

Longer maturity, fixed rate loans (forexample, 30-year conventional

mortgages) are more sensitive to

price risk from changes in ratesthan variable rate loans.

http://www.allbusiness.com/glossaries/interest-rate-

risk/4943665-1.html

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Interest rate risk is the risk(variability in value) borne by

an interest-bearing asset, such

as a loan or a bond, due tovariability of interest rates.

In general, Interest rate risk is

the exposure of banksfinancial condition to adverse

movements in interest rates



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Where does IRR come from?

Banks face four types of interest

rate risk:

Repricing risk

Yield curve risk

Basis risk

Option risk


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Repricing risk

The risk that arises from timing

differences or mismatches in thematurity and interest rate changes of abanks assets and liabilities

For example, if a long-term fixed-rateasset is funded with a short-termdeposit, interest income from the assetremains fixed over its life, while theinterest expense changes each time thedeposit is renewed. Because interestincome is fixed and interest expense can

move with market rate changes, netinterest income and underlyingeconomic value increase or decrease inresponse to market rates


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Yield curve risk

Another form of repricing risk, is the risk

that changes in market interest ratesmay have different effects on yields orprices on similar instruments withdifferent maturities

Short-term rates are normally lowerthan long-term rates, and banks earnprofits by borrowing short-term money(at lower rates) and investing in long-term assets (at higher rates)

But the relationship between short-termand long-term rates can shift quickly anddramatically, which can cause erraticchanges in revenues and expenses


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Basis risk Basis risk is the risk that changes in market

interest rates may have different effectson rates received or paid on instruments

with similar repricing characteristics

For example, a variable-rate loan whose

rate is based on the three-month Treasurybill rate that is funded with three-month

certificates of deposit

Because both instruments have a similar

repricing interval, there is no repricing risk Yet changes in the spread between the

two market interest rates can cause Bank

As net interest income to expand and

contract


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Options risk

Options risk is the risk that arisesfrom implicit and explicit options ina banks assets and liabilities

For instance, provisions in

agreements that allow loancustomers to prepay their loans orthat allow deposit holders towithdraw their funds early, withlittle or no penalty

These options, if exercised, canaffect net interest income andunderlying economic value


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Changes in interest rates,

affect a bank's earnings by changing its

net interest income and the level of

other interest sensitive income and

operating expenses

also affects the underlying value of the

bank's assets, liabilities and off-balance

sheet instruments because the presentvalue of future cash flows change when

interest rates change

Why manage IRR?


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Two most common perspectives for

assessing a bank's interest rate risk

exposure:

Earnings perspective

Economic value perspective

How to Assess IRR Exposure?


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Earnings Perspective

(Book Value Perspective)

Traditional approach to interest rate riskassessment taken by many banks which

perceives risk in terms of its effect on accountingearnings

Variation in earnings is an important focal pointfor interest rate risk analysis

Because reduced earnings - threaten the financialstability of an institution by undermining its

capital adequacy and by reducing marketconfidence

Component of earnings given most attention is -net interest income (i.e. the difference betweentotal interest income and total interest expense)


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Economic Value Perspective

(Market Value Perspective)

Perceives risk in terms of its effect on the

market value of a portfolio

Variation in market interest rates can affect

the economic value of a bank's assets,liabilities and off-balance sheet positions

Economic value of a bank can be viewed as the

present value of bank's expected net cash

flows Defined as the expected cash flows on assets

minus the expected cash flows on liabilities

Documents

IRR Overview Compile