Interest Rate Risk: Causes, Effects, and Management

This article discusses the causes, effects, and management of interest rate risk in financial institutions. It explores the relationship between interest rates and bond prices, as well as the factors that contribute to interest rate fluctuations. The article also provides insights into how financial institutions can measure and manage interest rate risk to mitigate potential losses.

Interest Rate Risk

Table of Contents
INTRODUCTION...........................................................................................................................3
TASK 1............................................................................................................................................3
Causes/sources of interest rate risk (IRR)..............................................................................3
TASK 2............................................................................................................................................5
How IRR affects financial institutions...................................................................................5
TASK 3............................................................................................................................................7
How Interest-rate risk is measured and managed by Financial Institution............................7
CONCLUSION................................................................................................................................9
REFERENCES..............................................................................................................................10

INTRODUCTION
Interest rate risk is the possibility of a relapse in the value of an asset resulting from
unpredicted fluctuations in interest rates. Interest rate risk is generally related with fixed income
assets (Bonds) instead than with equity investments. The interest rate is one of the primary
drivers of bond's price. According to this the present interest rate and the value of bond signifies
a wise-versa relationship. On other hand when the rates increases, the bonds price just decreases.
Although the value of all bonds are affected by interest rate fluctuations, the property of the
change varies among bonds.
TASK 1
Causes/sources of interest rate risk (IRR)
The banks are doing the business of transforming short- term deposits into longer term
loans, they are intrinsic al exposed to some level of interest rate risk. While in identifying the
appropriate, measure, and control these exposures are done by the management team of the bank
who does such programming (Gerlach, 2018). The given points describes the seven main causes
of difference in the rates of interest like Difference in risk, volume of loan, nature of security,
financial standings of the borrower, market imperfection, variation in demand and supply of
money and the period of loan. The causes are mentioned below:
1. Differences in Risk- The gross interest rates differentiate applying to the differences in
hazards and cost of maintain the accounts of borrowers, discomfort involved, in the
business of loaning etc. In simple words if the risk will be high the chances of increase in
rates will be high (Interest Rate Risk Management at Community Banks, 2021). The
interest rates are high in the private finance companies as compared to the interest rates
of banks because usually these companies’ takes less securities while giving the loans
and give the easy approval to the customers who ask for the loans.
2. Period of loan- It is simple the rate of interest depends on the tenure of the loan as if the
customer is taking a long for the long tenure the rate of interest will be high, as he has to
pay more interest and on the other side if the loan time is sort the customer has to pay less
rate of interest, as a short period of loan carries a low interest rate.
3. Volume of Loan- The amount of loan decides the rate of interest, basically the customer
who is taking a loan but the amount is high so he has to pay low rate of interest on the

other side if somebody is taking a less amount from the bank as loan then the rate of
interest charged will be high.
4. Nature of Security- The securities which are provided by the borrower to the banks or
the loan provider companies decides the rate of interest charged to them its depends on
the value of securities. If a borrower gives gold and government bonds against the loan he
is expecting will be charged less interest because these securities can be easily
convertible into cash (Salisu, 2021). It doesn't meant that the loan against the properties,
or the unmovable is not given, it will be but on the high rate of interest as these properties
cannot be converted to cash easily.
5. Financial standing of the Borrower- In this point financial standing of the borrower are
explained. According to the bank procedure if bank is having a proper knowledge about
the reputation and integrity can give the loan at low rate of interest. As the things may
come opposite then the rates get high. Although, on the other side if the government takes
the loan from the local citizens it pays low interest as no one consider or doubt on the
ability of the government to give the money back in due time.
6. Market Imperfection- It is found that if there are any kind of problems or the
imperfections they becomes the reason for the variation in rates of interest. The loan
providing companies are divided in different categories like the instance, banks, house
building banks private insurance companies which are specialized in charging different
interest rates. Monopoly towards the villager is shown so he enjoys some sort and
charges a high rate of interest. As they have lack of resources to cover such loan and they
are not able to give it back on the time given by the financial institution or the banks
7. Variation in Demand and Supply of Money- In last the demand for the money and the
supply of money in the different markets becomes the variation in rate of interest. As the
loan which are given for the agriculture are different from the commercial and the
industrial loans. As the demands and supply are different so lasts in high rates result.

TASK 2
How IRR affects financial institutions
The cost for changing of raw material into the use full one which manufacturing
industries face the interest rate risk for financial institution is also same. If some loan giving
companies like bank, non-banking finance company or the companies who provides house loans
are not able to manage interest rate risk properly, then the result comes to losses as if the
manufacturing organisation will not get proper cost of raw material or not able to manage it.
As the explanation of financial institution represent the businesses in which they take
money from the other one and give to the other one. These types of financial institution take the
money from the depositors they may both current and saving accounts holders or fixed
depositors or the debentures and corporate bonds and the investors in commercial papers. This
money is then again given back to the borrowers who needs home loans, consumer loans or the
corporates like working capital loans, project loans etc (Sun, 2018). Hence the finance giving
companies pays the rate of interest to the account holders and depositors and receives a rate of
interest from them. Only if it gets the good rate of interest then only it gives same to the
depositors otherwise it makes a loss. If the comparison is done from the manufacturing
organisation then the pay system depends on the good sold or cost of raw material for the
financial institution. The rate of interest which is received from the borrowers is the sales price
of goods (What is IRR and How Does it Work, 2021). It the sales price which is received by the
organisation is less than the cost price of the raw material then organisation has to face a loss
(Guirguis, 2021) . As like if low rates of interest is received by the financial companies from the
consumers then what the company will pay to their depositors and face the loss.
Sometimes in the premises loan giving organisation raise the money from the customers
who have deposited money taking a short time and then they just rotate this money in giving

long term loans like home loans etc. In this type of cases these companies just have to keep
renewing the short term borrowings so it the long term loans can be managed properly, this make
situations of asset liabilities mismatch.
Assets liabilities mismatch is an important risk for the financial organization because the
counterparties, which have given it short- term funds, may demand it back whereas the financial
institution would not have money to pay them back because all its money would be stuck in long
term loans given by it. Separate from the asset liabilities mismatch, the habit of raising money
from short term depositors/investors and directing it for long term loans increase another risk for
financial institutions, which is called interest rate risk.
Interest rate risk arises when the rate at which the loans are given by the financial
institution is fixed whereas the rate at which it has upraised money from the depositors/investors
is variable. If the depositors ask for a higher rate from the financial institution and it is not able to
pass on this increased cost of funds to its borrowers, then the financial institution faces the risk of
losses. This is called interest-rate-risk. The further increases in cases where the loans given by
the financial institution with fixed interest rate are long term loans and the deposits raised at
variable interest-rate are short term deposits like commercial papers.
Even when financial institution give loans at fixed interest rate loans, in the terms and
conditions, they incorporate provisions that if the interest rates rise beyond a limit then financial
institution keep the right to increase the interest rates even on these fixed interest rate loans.

Whenever financial institutions lend at fixed interest rates, then they keep the interest-rate
differential high for such customers so that the financial institutions can bear a higher increase in
its borrowing costs before it start making losses (Yung, 2021). Lend at floating interest rates so
that they can pass on the impact of increasing borrowings rates to customers and thereby avoid
losses.
TASK 3
How Interest-rate risk is measured and managed by Financial Institution
Management and Measurement of Interest-rate risk is so much essential, first thing which
is necessary to understand how interest-rate risk can be managed (Ali, 2020). As it can affect and
make the financial institution in position of not working and finally insolvent. There are some
methods which can be helpful in managing the interest-rate are explained below-
Diversification- Between the different options which are working in the institution to
manage the interest-rate risk which is related with them, beyond this a step should be taken to
distribute their financial investment. This is the best method for the customers who usually invest
in such things they can manage the risk which is associated with the interest rates.
Safer investments – the best and the safest option for the investors and on usually bases
who are trying to lower the risks concerned with interest rates is to take or invest in certificates
and bonds as they can be converted into cash and their maturity time is also short. Compared to
long tenure the short maturity has low susceptible to function in interest rate. By the use of this

method the management decreases the chance of being pointed to interest rate up down's since
the maturity tenure is less.
Hedging- By using this option the risk of interest rate can be reduced, while purchasing so
many type of derivatives that can be easily obtainable there are different ways of hedging. Some
of them are mentioned below:
 Forwards- The basic technique is to tackle the interest rate risks, on this option the
different types of strategies are used as it’s the important point. In this method of the
management a proper agreement is maid for any kind of business or exchange
agreements. As the exchange is ready for the future.
 Forward rate agreements- As the name itself showing the process, it is the process in
which the gain and loss is decided.
 Swaps- This method is having similarities like the Forward rate agreements, as this
method is also used to manage the risks and this process works upon the involvement of
two different parties.
Selling Long term bonds- In this method the basic formula is used that is to sell the long
term bonds which are present right now, in the result the investments get cleared and a person
can reinvest in the bonds with the best returns (Ushakova,2018)). Now it will be easy for
reinvestment in securities, as these having short term tenure and low risk.
Purchasing floating rate bonds- As these bonds are fluctuating and having names, rate of
interest which are circulated in all over the market. Investing in these bonds is something
beneficial and sometimes do not get profit as these are fluctuating and keeps on moving up and
down. These bonds are taken in good proportions as these are interconnected of short and long
term. On the other side it does not mean that it always use full for getting exact return, although
it helps in decreasing the interest rate risk which is involved.

Interest rate risk is holding a best financial measurement, and mainly with the securities
which are fixed, and helps in understanding the fluctuations in the fixed income securities. As if
rate are increased through the kind of movement in bonds may be liquidated. They go up when
the value of interest rates go down, and opposite when these rates go up (George, 2020). The
government and the companies which sell the bonds to get money back pay a fix rate of interest
on amount that is known as coupon rate. These bonds have their own face value, these bonds are
also calculated with maturity level the years can be so long like 30 years, even more than this.
When these bond completes the maturity time, the borrower have to pay it back at the par value.
As the bonds price keep on fluctuating so the investors trade the bonds on the markets who’s
having securities at best. The rate of interest is known as bond's yield.
While looking for the present value of the bond, the person can get to know the price of
bond from the broker or the services which are made for the bond listening. These types of bonds
put the prices on their face value not on the dollar amount. The bonds which are purchased by
investors they do it on prior bases to generate the income. The annual rate of return which is
expected known as current yield thus it meant to be the function of the present price and the
bonds pays the amount of interest (Tang, 2021). And on the other hand the bonds which are
issued by the government and the companies are taken and sold in the market of the bond. This
thing relates to the change in the values, so investor has to understand the relation in the yield
and price, and have to learn how they can get to know the present yield.
CONCLUSION
From the above report it is concluded that what can be causes of interest rate risk, how it
can be measured and how can the financial Institutions can be affected by it. It all depend upon
the motion of markets as if market have the boom the rates get increases and if somehow it’s not
that profitable then the interest rates go down (Wang,2021). In equally the sometimes investors
get affected by the interest rate risk. It can be also concluded that a person or an organisation
should critically analyse the whole market to evaluate the different types of risks related to
market finance.

REFERENCES
Books and Journals
Gerlach, J.R., Mora, N. & Uysal, P., (2018). Bank funding costs in a rising interest rate
environment. Journal of Banking & Finance, 87, pp.164-186.
Salisu, A.A. & Vo, X.V., (2021). The behavior of exchange rate and stock returns in high and
low interest rate environments. International Review of Economics & Finance, 74,
pp.138-149.
Sun, J., Li, Y. & Zhang, L., (2018). Robust portfolio choice for a defined contribution pension
plan with stochastic income and interest rate. Communications in Statistics-Theory and
Methods, 47(17), pp.4106-4130.
Guirguis, M., (2021). Estimating the Payoff of an Interest Rate Cap and Floor on LIBOR with
Different Interest Rates from a Collar Interest Rate. Available at SSRN 3822186.
Yung, J., (2021). Can interest rate factors explain exchange rate fluctuations?. Journal of
Empirical Finance, 61(C), pp.34-56.
Ali, S., Siddiqi, M.F. & Zubair, S., (2020). Determinants of Corporate Hedging Policy: The use
of Interest Rate Derivatives by Non-Financial Firms of Pakistan. RADS Journal of
Business Management, 2(2).
Ushakova, Y. & Kruglova, A., (2018). Competition in Russia's Banking Sector Prior to and After
Supervision Policy Enhancement: Conclusions Based on Interest Rate Dispersion and
Spread. Russian Journal of Money and Finance, 77(2), pp.22-50.
Tang, K.B & et.al., (2021). Valuation of callable accreting interest rate swaps: Least squares
Monte-Carlo method under Hull-White interest rate model. The North American
Journal of Economics and Finance, 56, p.101339.
George, A., Xie, T. & Alba, J.D., (2020). Central bank digital currency with adjustable interest
rate in small open economies. Available at SSRN 3605918.
Wang, K. & Mao, Y., (2021). Asymptotics of the finite-time ruin probability of dependent risk
model perturbed by diffusion with a constant interest rate. Communications in Statistics-
Theory and Methods, 50(4).pp.932-943.

Online
Interest Rate Risk Management at Community Banks, 2021.[Online]Available
through:<https://communitybankingconnections.org/articles/2012/Q3/interest-rate-risk-
management>
What is IRR and How Does it Works, 2021. [Online].Available
through:<https://propertymetrics.com/blog/what-is-irr/#disqus_thread>