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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_risk7/30/2019 IRR Overview Compile
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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
http://www.allbusiness.com/glossaries/accounting/4941809-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/accounting/4941809-1.html7/30/2019 IRR Overview Compile
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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)?
http://www.allbusiness.com/glossaries/insurance/4941807-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/insurance/4941807-1.html7/30/2019 IRR Overview Compile
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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
What is Interest Rate Risk (IRR)?
http://www.allbusiness.com/glossaries/banking/4941812-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/interest-rate-risk/4943665-1.htmlhttp://www.allbusiness.com/glossaries/banking/4941812-1.html7/30/2019 IRR Overview Compile
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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
What is Interest Rate Risk (IRR)?
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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