Definition
Interest-Rate Risk, also known as interest-rate exposure, is the risk that changes in interest rates will affect the value of fixed-interest assets and liabilities. This phenomenon has been thoroughly analyzed over recent decades, especially with examples like the 1980s crisis faced by savings and loan associations (S&L) in the USA. Different forms of interest-rate risk include the risk of changes in interest rates affecting fixed-interest assets and liabilities, mismatches in asset and liability repricing, prepayment risk, reinvestment risk, and extended repayment periods as interest rates rise.
Forms of Interest-Rate Risk
- Fixed-Interest Asset and Liability Value Impact: Changes in interest rates can affect the market value of assets and liabilities that have a fixed interest rate.
- Mismatches in Repricing: Discrepancies in the timing of repricing or refinancing of assets and liabilities can result in interest rate mismatches.
- Prepayment Risk: The risk that borrowers might repay their obligations, such as a mortgage, early, affecting the lender’s anticipated cash flows and interest income.
- Reinvestment Risk: The risk that proceeds from interest or principal payments will be reinvested at lower rates than the original investment.
- Repayment Duration Risk: As interest rates rise, the duration of repayments may extend beyond original expectations, affecting investment plans.
Examples
- Savings and Loan Associations (1980s Crisis): S&Ls continued to provide fixed-rate loans while interest rates climbed, resulting in constant interest revenue but rising interest costs, leading to a financial crisis.
- Prepayment of Mortgages: Homeowners may repay their fixed-rate mortgages early when interest rates drop, leading lenders to reinvest these funds at lower current rates, reducing expected income.
- Bond Investments: Investors holding long-term fixed-rate bonds may see the market value of these bonds fall if interest rates rise, impacting their portfolio value.
Frequently Asked Questions (FAQs)
What is Interest-Rate Risk?
Interest-Rate Risk refers to the risk posed by movements in interest rates that may negatively impact the value or returns of financial assets and liabilities.
Why is Interest-Rate Risk important?
Managing interest-rate risk is crucial for institutions, especially those dealing in large volumes of fixed-income securities, loans, and mortgages, to protect against potential financial losses.
How can organizations manage Interest-Rate Risk?
Organizations can manage interest-rate risk through various techniques, such as hedging with derivatives, diversifying their asset and liability portfolios, duration matching, and conducting regular interest-rate risk assessments.
What was the 1980s savings and loan crisis?
During the 1980s, many U.S. savings and loan associations faced insolvency because they continued to offer fixed-rate loans despite rising interest rates, leading to a significant mismatch between their revenue streams and rising interest liabilities.
What is Reinvestment Risk?
Reinvestment Risk is the risk that cash flows from existing investments will be reinvested at lower interest rates, especially during declining interest rate environments.
Related Terms
- Fixed-Interest Asset: A financial instrument that pays a fixed rate of interest over its term.
- Hedging: A risk management strategy used to offset potential losses in one asset by investing in another.
- Duration: A measure of the sensitivity of the price of a fixed-income investment to a change in interest rates.
Online References
Suggested Books
- “Fixed Income Securities: Tools for Today’s Markets” by Bruce Tuckman and Angel Serrat - A comprehensive guide to fixed-income securities, including the intricacies of managing interest-rate risk.
- “The Handbook of Fixed Income Securities” by Frank J. Fabozzi - This book offers an extensive look into various fixed-income securities and the risks associated with them.
- “Interest Rate Risk Modeling” by Sanjay K. Nawalkha, Gloria M. Soto, Natalia A. Beliaeva - A detailed resource for understanding and modeling interest-rate risk in financial markets.
Accounting Basics: “Interest-Rate Risk” Fundamentals Quiz
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