Models for Interest Rate Risk Essay

Interest risk is the possibility of unexpected adverse changes in interest revenues and expenses. It can be shown that interest rate changes are unpredictable almost 100%. They depend on monetary policy; supply and demand, inflation etc. These in turn depend on many other factors. So how do financial institutions manage the risk of fluctuating interest rates give that they cannot predict it? The immunization of a portfolio against interest rate risk means that the portfolio will neither gain nor lose value if interest rates change. In this essay we will look at some of the different models used by financial institutions for managing interest rate risk. They are the re-pricing model, the maturity model and the duration model. We will describe them and evaluate the comparative advantages and disadvantages each model assumes. Firstly we consider the re-pricing model. It is a balance sheet where assets and liabilities are grouped according to the time periods in which the different assets and liabilities are rate sensitive. Assets or liabilities are rate sensitive within a given time period if the values of each are subject to receiving a different interest rate should market rates change. These groupings are referred to as ‘maturity buckets’. Then ‘Gap analysis’ is conducted where the rate sensitive liabilities are subtracted from rate sensitive assets for each maturity bucket. This is called the GAP. It can be shown that GAP * interest change = net interest income (or profit) change or the interest margin. We can also calculate the cumulative gap(CGAP) by adding up the gaps in the brackets over a period of time, for example 1 year.