Interest Rate Risk

Interest rate risk arises from several sources, including:

• Changes in the level of interest rates (absolute interest rate risk)

• Changes in the shape of the yield curve (yield curve risk)

• Mismatches between exposure and the risk management strategies undertaken (basis risk)

Interest rate risk is the probability of an adverse impact on profitability or asset value as a result of interest rate changes. Interest rate risk affects many organizations, both borrowers and investors, and it particularly affects capital-intensive industries and sectors.

Changes affect borrowers through the cost of funds. For example, a corporate borrower that utilizes floating interest rate debt is exposed to rising interest rates that could increase the company’s cost of funds. ATIPS & TECHNIQUES portfolio of fixed income securities has exposure to interest rates through both changes in yield and gains or losses on assets held.

Absolute Interest Rate Risk

Absolute interest rate risk results from the possibility of a directional, or up or down, change in interest rates. Most organizations monitor absolute interest rate risk in their risk assessments, due to both its visibility and its potential for affecting profitability.

From a borrower’s perspective, rising interest rates might result in higher project costs and changes to financing or strategic plans. From an investor or lender perspective, a decline in interest rates results in lower interest income given the same investment, or alternatively, inadequate return on investments held. All else being equal, the greater the duration, the greater the impact of an interest rate change.

The most common method of hedging absolute interest rate risk is to match the duration of assets and liabilities, or replace floating interest rate borrowing or investments with fixed interest rate debt or investments. Another alternative is to hedge the interest rate risk with tools such as forward rate agreements, swaps, and interest rate caps, floors, and collars.

Yield Curve Risk

Yield curve risk results from changes in the relationship between short and long-term interest rates. In a normal interest rate environment, the yield curve has an upward-sloping shape to it. Longer-term interest rates are higher than shorter-term interest rates because of higher risk to the lender. The steepening or flattening of the yield curve changes the interest rate differential between maturities, which can impact borrowing and investment decisions and therefore profitability.

In an inverted yield curve environment, demand for short-term funds pushes short-term rates above long-term rates. The yield curve may appear inverted or flat across most maturities, or alternatively only in certain maturity segments. In such an environment, rates of longer terms to maturity may be impacted less than shorter terms to maturity. When there is a mismatch between an organization’s assets and liabilities, yield curve risk should be assessed as a component of the organization’s interest rate risk.

When the yield curve steepens, interest rates for longer maturities increase more than interest rates for shorter terms as demand for longer-term financing increases. Alternatively, short-term rates may drop while long-term rates remain relatively unchanged. A steeper yield curve results in a greater interest rate differential between short-term and long-term interest rates, which makes rolling debt forward more expensive. If a borrower is faced with a steep yield curve, there is a much greater cost to lock in borrowing costs for a longer term compared with a shorter term.

A flatter yield curve has a smaller gap between long- and short-term interest rates. This may occur as longer-term rates drop while short-term rates remain about the same. Alternatively, short-term demand for funds may ease,with little change to demand for longer-term funds. The flattening of the yield curve makes rolling debt forward cheaper because there is a smaller interest rate differential between maturity dates. Yield curve swaps and strategies using products such as interest rate futures and forward rate agreements along the yield curve can take advantage of changes in the shape of the yield curve. The yield curve is a consideration whenever there is a mismatch between assets and liabilities.

Reinvestment or Refunding Risk

Reinvestment or refunding risk arises when interest rates at investment maturities (or debt maturities) result in funds being reinvested (or refinanced) at current market rates that are worse than forecast or anticipated. The inability to forecast the rollover rate with certainty has the potential to impact overall profitability of the investment or project. For example, a short-term money market investor is exposed to the possibility of lower interest rates when current holdings mature. Investors who purchase callable bonds are also exposed to reinvestment risk. If callable bonds are called by the issuer because interest rates have fallen, the investor will have proceeds to reinvest at subsequently lower rates. Similarly, a borrower that issues commercial paper to finance longer term projects is exposed to the potential for higher rates at the rollover or refinancing date. As a result, matching funding duration to that of the underlying project reduces exposure to refunding risk.

Basis Risk

Basis risk is the risk that a hedge, such as a derivatives contract, does not move with the direction or magnitude to offset the underlying exposure, and it is a concern whenever there is a mismatch. Basis risk may occur when one hedging product is used as a proxy hedge for the underlying exposure, possibly because an appropriate hedge is expensive or impossible to find. The basis may narrow or widen, with potential for gains or losses as a result.

A narrower view of basis risk applies to futures prices, where basis is the difference between the cash and futures price. Over time, the relationship between the two prices may change, impacting the hedge. For example, if the price of a bond futures contract does not change in value in the same magnitude as the underlying interest rate exposure, the hedger may suffer a loss as a result.

Basis risk can also arise if prices are prevented from fully reflecting underlying market changes. This could potentially occur with some futures contracts, for example, where daily maximum price fluctuations are permitted. In the case of a significant intra-day market move, some futures prices may reach their limits and be prevented from moving the full intra-day price change.