Risks and Basel III

Risks and Basel III

Part A

1. Interest Rate Risk

1.1 Definition

Fluctuating interest rates may give rise to a risk most commonly known as interest rate risk. Such risk is generally experienced by bond owners. The level of risk is closely dependent upon the rate of interest prevailing in the market. The greater the price sensitivity a bond has in the market, the greater the interest rate risk it carries. The sensitivity of the bond is dependent upon two things, the coupon rate the bond carries and time remaining to bond maturity. The greater the time left in the maturity of the bond the greater the risk it carries. For bond holders it is one of the most significant risks they need to be worried about. More directly than stocks, the value of bonds is affected by the interest rate risk. The bond prices fall as and when the interest rate rise and vice versa. The logic behind this assumption is that as the rate of interest increases, the opportunity cost associated with the possession of bond decreases. This is because other investments that reflect higher yields of interest attract more investor attention so they are more inclined to switch to that. To understand the definition of this concept with an example, it can be discussed that if the interest rates decrease and are less than the interest rate offered by the Bond, Bond's attractiveness will increase as it is offering a higher rate of return than the market has to offer (Investopedia.com, 2013).

1.2 Sources in relation to Basel Committee for Banking Supervision

1.2.1 Reprising risk

This risk arises due to the maturity timing differences of floating rate and fixed rate of bank assets and liabilities. Although such mismatches are a regular part of the Bank's operations, they may expose the bank to unexpected fluctuations.

1.2.2 Yield curve risk

The shape and slope of the yield curve may be changed by the reprising mismatches. When the bank's income is adversely affected by the unexpected shifts in the yield curve, such risk arises.

1.2.3 Basis risk

When the adjustment of rate is imperfectly correlated with instruments of similar reprising characteristics, such risks arise. Cash flows can change unexpectedly if the interest rate changes.

1.3 Measurement in relation to Basel Committee for Banking Supervision

Calculating and measuring interest rate risk is a complex task. Stimulating movements in yield curves is used to analyse interest rate risk. Heath-Jarrow-Morton framework is used to make sure that movement in the yield curve are consistent with current market yield values. This is done to ensure that riskless arbitrage is not possible. David Heath of Cornell University, Robert A. Jarrow of Kamakura Corporation and Andrew Morton of Lehman Brothers developed the Heath-Jarrow-Morton framework in 1991. The impact of varying interest rates can be calculated by a number of standard calculations which are based on various liabilities and assets. Techniques include:

Market to market: it includes computing the fair value of liabilities and assets.

The yield curve is shifted in a specific way to stress test ...