Question

Interest rate risk is one of the problems faced by most of the commercial banks.

(i) Define and explain the development of interest rate risk management. (3 marks)

(ii) Discuss and explain the measurement model or technique that is used to measure the interest rate risk. (6 marks)

(iv) Discuss TWO hedging techniques for interest rate risk encountered by financial institution. (6 marks)

Answer 1

i) Interest rate risk is risk of fluctuation of interest rate which exists on varioua assets such as loan which may affect the value of asset.Interest rate risk management refers to the management of such risk using various risk management techniques or tools.Interest rate risk basically impact fixed income investor rather than equity investor.Various hedging techniques were used to hedge interest rate fluctuation.

ii) Gap Analysis model : This model is a management of asset and liability in order to assess interest rate risk.This model uses Internal rate of return as it basis which reflects the difference between rate variant asset and liability in the given period of time.This technique used in the assessment of risk on the fixed income assets based on total assets and liability.

Duration Model : The duration of the risk bearing asset to repay the cash flows helps in determining interest rate risk.The higher the duration the higher is the rise in the interest rate and greater the interest rate risk.

Simulation model : This model helps in determining interest rate risk by considering both present and future business scenarios.This model basically evaluate the impact of the strategy of business in interest rate variation.

iii) Two hedging techniques used by financial institution is interest rate swaps and forward contract.

Interest rate swap is used to prevent against adverse interest rate movements.It allows to offer a fixed rate of interest without any fluctuation this it hedge interest rate variation.

Forward contract is hedging technique which is used to prevent interest rate fluctuation by contracting or fixing the interest rate is advance for certain transactions to be executed in future.