Interest Rate Risk and Bank Risk Management

Flashcards based on the key concepts and definitions related to Interest Rate Risk and Bank Risk Management.

What is Interest Rate Risk (IRR)?

The risk due to a change in market interest rates that may affect the value of a fixed-income instrument owned by a bank.

How does a bank experience financial loss related to IRR?

A bank experiences financial loss to the extent that the security constitutes an open position, meaning the changes in value of other instruments in the portfolio do not completely offset the position.

What is the term structure of interest rates?

The relationship between the time until maturity of bonds of a particular credit rating and the discount rates applied to discount estimated future cash flows from the bonds.

What does 'steepening the curve' refer to in terms of yield curves?

It refers to a situation where the difference between short-term and long-term interest rates increases, causing the yield curve to become steeper.

What is Net Interest Income (NII)?

NII is calculated as Interest Income minus Interest Expense.

What are Rate Sensitive Assets (RSA)?

Assets that will mature or re-price in a given time period, affecting the bank’s interest income.

What is static GAP analysis?

A static measure of risk that analyzes the difference in the amounts of rate sensitive assets and rate sensitive liabilities.

What do changes in the level of interest rates affect?

They affect net interest income, the spread between asset yields and liability costs, and the volume of interest-bearing assets.

What is the impact of a negative GAP in the context of interest rates?

More liabilities than assets are re-priced higher, hence net interest income and net interest margin will fall.

What are interest rate derivatives?

Financial instruments whose values are derived from underlying assets or rates, used to manage interest rate risks.

What distinguishes a 'call option' from a 'put option'?

A call option allows the buyer to purchase the underlying asset at a predetermined price, while a put option gives the holder the right to sell the underlying asset at a predetermined price.

What is 'financial engineering'?

The use of derivatives like forwards, swaps, and options to construct sophisticated financial products that manage risks.

What factors contribute to Interest Rate Risk (IRR)?

Factors include maturity of the instrument, coupon rate, and the overall economic environment.

How can banks manage Interest Rate Risk (IRR)?

Banks can use strategies like interest rate swaps, diversification of assets, and adjusting asset-liability management practices.

Why is Interest Rate Risk (IRR) important for fixed-income instruments?

It is important because fluctuations in interest rates can lead to significant changes in the market value of these instruments, impacting a bank's financial stability.