Laying the Foundation For Interest Rate Risk Management
When it comes to handling floating-rate investments, corporations and investors alike become vulnerable to potential changes in interest rates. In our (somewhat fleeting) contemporary scenario, understanding Interest Rate Risk (IRR) becomes even more paramount to the success of financial endeavors; so much so that even Warren Buffet has defined interest rate as the most important item over time in valuation.
So we thought we’d offer you this comprehensive guide to Interest Rate Risk Management to help you make the best decision for your organization…
What Are the Key Drivers of Interest Rate Risk?
By definition, IRR is the potential of an increase or decrease in earnings and market value generated from fluctuations in the market rate.
Understanding the driving force behind what determines IRR and an institution’s level of exposure to risk will help you manage risk and make educated financial decisions.
For starters, it is important to recognize IRR as an integral part of the balance sheet. In fact, IRR will arise from multiple points such as mismatches in the maturity of assets and liability or in the driver rate relationship. Observing non-maturity deposit behavior can also provide insight into the level of risk involved in a given investment. IRR will be at the core of virtually all balance sheet elements such as loans, investments, funding, and equities – the behaviors of which will inevitably vary depending on interest rate changes.
There are four main generic types of IRR: Repricing Risk, Options Risk, and Yield Curve Risk.
Repricing Risk
Derived from a misalignment or time gap between the maturity and repricing of an asset and the source of its funding, repricing risk is usually the result of fluctuations in the market interest rate.
Options Risk
On the other hand, Options Risk happens when the asset presents a difference from its funding source. In this case, variations in interest rate are responsible for the maturity or repricing of an asset.
As for Yield Curve Risk, we delve further into this in the section below
Maximizing the chances of successful risk management will depend on the correct identification of the type of risk at hand. Gaining insight into IRR types will help you choose the best course of action.
Foundations of IRR Methodologies - Net Interest Income (NII)
Among the main IRR methodologies, we find Net Interest Income (NII) analysis. By NII we refer to a financial tool designed to measure the revenue generated from interest-bearing assets vs interest liabilities.
The standard modeling practice for NII IRR analysis aims to identify the risk in balance sheet associated with changes in interest rate. It also measures the change in net interest income across all possible rate scenarios so as to determine earning at risks - a.k.a. the amount of change in net income subject to change over a set timeline.
Understanding IRR Results
Calculating IRR will help project the outcome of a determined investment. To maximize the chance of success, the projected IRR should be greater than the minimum required rate of return. The balance sheet structure will play a paramount role in driving risk. An asset-sensitive balance sheet will take into account the link between rate and earning increase along with exhibit’s assets. Typical balance sheets will project assets (repricing/maturing over the short term) and liabilities (reduced rate sensitivity in the fixed and long-term).
The Economic Value of Equity (EVE)/Net Economic Value (NEV)
When assessing the scope of their Rate Interest Risk exposure, financial institutions should consider earnings and perspectives. This is usually done through the Economic Value of Equity (EVE), which is a cash flow calculation taking into account the value of all asset cash flows minus the current value of all liability cash flows. Simply put, EVE is the Net Economic Value (NEV) of an investor’s balance sheet cash flow. It is carried out by calculating the present asset value minus the present value of liabilities.
Exploring Additional Risks (Yield Curve, Basis & Option Risk)
We have already seen how different measures will serve different purposes in the scope of risk management. Whilst policy measures such as NII and EVE/NEV Rate Shocks will give insight into the trends influenced by balance sheet changes and asset exposure to rates, Dynamic measures for NII will shed a light on important elements of strategic management such as new purchases/sales or hedging strategies.
In the case of Yield Curve Risk, the pricing characteristics of an asset and its funding source are calculated based on different points on the same curve. Changes in the curve shapes will signal to risk - hence bear a possible negative impact on earnings. A thorough understanding of an institution’s exposure to risk will help the layout of an effective risk-management strategy.
A Yield Curve Risk Assessment is usually implemented analyzing short-term vs long-term rates. Through Basis Risk assessment, institutions should also be able to identify any disconnects between market rates or repricing indices by assessing a variable index relationship against all constants.
Conclusion
Gaining insight into the ins and outs of Interest Rate Risk Management is fundamental to your business’s success. Prior to making an investment, your institution should analyze the three key drivers of inherent interest rate risk - repricing, maturity, and cash flows, as well as measuring NII IRR and EVE (NEV) whilst also assessing its balance sheet structure and exposure to risk.
If you would like to improve your understanding of Rate Risk Management and brainstorm ad-hoc solutions for your project or investment, feel free to download our guide.
Written for MountainView Risk and Analytics December 2021
