INTEREST RATE RISK

INTEREST RATE RISK



Interest Rate Risk

Interest rate risk is the probability of reducing the rate of profit when the interest rate (discount rate). With the growth of the market rate of return, the value of securities with fixed charges (such as coupon bond) decreases, and vice versa. The degree of interest rate risk depends on the maturity of the securities, in the greater risk of interest rate securities with long maturity. The Interest rate risk is the value of the security changes due to changes in interest rates. For example, the bond price decreases with an increase in interest rates. In the case of a depository institution is also called risk in debt funding (funding risk), then there is the risk that income will suffer from changes in interest rates. Adverse interest rates changes including: - Immediate changes in interest rates; - Changes in the shape of the curve of income; - Changes in the volatility of interest rates; - Changes in the relationship or the distribution between the various indices of interest rates; - Early repayment of principal.

Measurement of Interest Rate Risk

Example: Compute the Interest-Rate Risk ExposureLets take an option-free bond with an 8% coupon, ten-year bond with a price of 125. Yield to maturity is 7% Answer: Scenario 1 is an increase of 50bps that drives the price down to 120 (this is just an estimate). To see the percentage change you take the new price after the yield change and subtract it from the initial price after the change divided by the initial price.120 - 125 / 125 = -.04 = a 4 % decrease in the price of the bond due to a 50 bps changeScenario 2 is an increase of 100 bps that drives the price down to 114.114 - 125 / 125 = - .088 = an 8.8% decrease in price due to a 100 bps change.You can use this for any type of scenario concerning a change in yields.

Future contracts

Futures contract is a contractual obligation to buy, sell, respectively, in a standardized date of the contract specified, the standardized number of financial instruments at a price predetermined (agreed) in the free exchange trades.

A futures contract is an agreement for the purchase or sale of a futures contract A is an Agreement for the purchase or out of a specific amount of a financial instrument or commodity within Amount of a specific instrument or commodity

ILLUSTRATION

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