Interest Rate Risk

Chapter 4

Risk Management and Financial Institutions, 5e, Chapter 9, Copyright © John C. Hull 2018 1
 Interest Rate Risk
 Interest rate risk is the potential for
investment losses that can be triggered by
a move upward in the prevailing rates for
new debt instruments. If interest rates rise,
for instance, the value of a bond or other
fixed-income investment in the secondary
market will decline. The change in a
bond's price given a change in interest
rates is known as its duration.
Risk Management and Financial Institutions, 5e, Chapter 9, Copyright © John C. Hull 2018 2
 Interest Rate Risk
 As interest rates rise bond prices fall, and
vice versa. This means that the market
price of existing bonds drops to offset the
more attractive rates of new bond issues.
 Interest rate risk can be reduced through
diversification of bond maturities or
hedged using interest rate derivatives.

Risk Management and Financial Institutions, 5e, Chapter 9, Copyright © John C. Hull 2018 3
 Interest Rate Risk
 Interest rate risk is the potential that a
change in overall interest rates will reduce
the value of a bond or other fixed-rate
investment.
 interest rate risk is measured by a fixed
income security's duration, with longer-
term bonds having a greater price
sensitivity to rate changes.
Risk Management and Financial Institutions, 5e, Chapter 9, Copyright © John C. Hull 2018 4
 What Is the London Interbank
Offered Rate (LIBOR)?
 The London Interbank Offered Rate
(LIBOR) was a benchmark interest rate at
which major global banks lent to one
another in the international interbank
market for short-term loans.

Risk Management and Financial Institutions, 5e, Chapter 9, Copyright © John C. Hull 2018 5
 LIBOR
 LIBOR was the benchmark interest rate at
which major global banks lend to one
another.
 LIBOR was administered by the
Intercontinental Exchange, which asks
major global banks how much they would
charge other banks for short-term loans.

Risk Management and Financial Institutions, 5e, Chapter 9, Copyright © John C. Hull 2018 6
 LIBOR
 The rate was calculated using the
Waterfall Methodology, a standardized,
transaction-based, data-driven, layered
method.
 LIBOR has been subject to manipulation,
scandal, and methodological critique,
making it less credible today as a
benchmark rate.
Risk Management and Financial Institutions, 5e, Chapter 9, Copyright © John C. Hull 2018 7
 LIBOR
 LIBOR was also the basis for consumer loans in
countries around the world, so it impacts
consumers just as much as it does financial
institutions. The interest rates on various credit
products such as credit cards, car loans, and
adjustable-rate mortgages fluctuate based on
the interbank rate . This change in rate helps
determine the ease of borrowing between banks
and consumers.

Risk Management and Financial Institutions, 5e, Chapter 9, Copyright © John C. Hull 2018 8
 Uses of LIBOR
 Standard interbank products like forward rate
agreements (FRA), interest rate swaps, interest
rate futures, options, and swap, whereby options
provide buyers with the right, but not the
obligation, to purchase a security or interest rate
product
 Commercial products like floating rate
certificates of deposit and notes, variable rate
mortgages, and syndicated loans, which are
loans offered by a group of lenders
Risk Management and Financial Institutions, 5e, Chapter 9, Copyright © John C. Hull 2018 9
 Uses of LIBOR
 Hybrid products like
collateralized debt obligations (CDO),
collateralized mortgage obligations (CMO), and
a wide variety of accrual notes, callable notes,
and perpetual notes
 Consumer loan-related products like individual
mortgages and student loans

Risk Management and Financial Institutions, 5e, Chapter 9, Copyright © John C. Hull 2018 10
 LIBOR Rates and Swap Rates
 LIBOR rates are rates with maturities up to
one year for interbank transactions where
the borrower has an AA rating
 Swap rates are the fixed rates exchanged
for floating in an interest rate swap
agreement

Risk Management and Financial Institutions, 5e, Chapter 9, Copyright © John C. Hull 2018 11
 Understanding Swap Rates
 A bank can
 Lend to series AA-rated borrowers for 10
successive six-month periods
 Swap the LIBOR interest received for the
five-year swap rate
 This shows that the swap rate has the
credit risk corresponding to a series of
short-term loans to AA-rated borrowers

Risk Management and Financial Institutions, 5e, Chapter 9, Copyright © John C. Hull 2018 12
 Risk-Free Rate
 Traders have traditionally assumed that
the LIBOR/swap zero curve is the risk-free
zero curve
 The Treasury curve is on average about
50 basis points below the LIBOR/swap
zero curve
 Treasury rates are considered to be
artificially low for a variety of regulatory
and tax reasons
Risk Management and Financial Institutions, 5e, Chapter 9, Copyright © John C. Hull 2018 13
 Repo Rate
 Repo rate is the rate at which the central
bank of a country (Reserve Bank of India
in case of India) lends money to
commercial banks in the event of any
shortfall of funds. Repo rate is used by
monetary authorities to control inflation.

Risk Management and Financial Institutions, 5e, Chapter 9, Copyright © John C. Hull 2018 14
 Repo Rate
 In the event of inflation, central banks
increase repo rate as this acts as a
disincentive for banks to borrow from the
central bank. This ultimately reduces the
money supply in the economy and thus
helps in arresting inflation..

Risk Management and Financial Institutions, 5e, Chapter 9, Copyright © John C. Hull 2018 15
 Repo Rate
 he central bank takes the contrary position
in the event of a fall in inflationary
pressures. Repo and reverse repo rates
form a part of the liquidity adjustment
facility.

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