Interest rate risk

Interest rate risk is risk to the earnings or market value of a portfolio due to uncertain future interest rates. Discussions of interest rate risk can be confusing because there are two fundamentally different ways of approaching the topic. People who are accustomed to one often have difficulty grasping the other. The two perspectives are:

 a book value perspective, which perceives risk in terms of its effect on accounting earnings, and

a market value perspective—sometimes called an economic perspective—which perceives risk in terms of its effect on the market value of a portfolio.

The first perspective is typical in banking, insurance and corporate treasuries, where book value accounting prevails. The latter is typical in a trading or investment management context.

Interest rate risks can be categorized in different ways, and there is usually some overlap between categories. One approach—that is well suited for a book-value perspective—is to break interest rate risk into three components:Term structure risk (also called yield curve risk or repricing risk) is risk due to changes in the fixed income term structure. It arises if interest rates are fixed on liabilities for periods that differ from those on offsetting assets. One reason may be maturity mismatches. Suppose an insurance company is earning 6% on an asset supporting a liability on which it is paying 4%. The asset matures in two years while the liability matures in ten. In two years, the firm will have to reinvest the proceeds from the asset. If interest rates fall, it could end up reinvesting at 3%. For the remaining eight years, it would earn 3% on the new asset while continuing to pay 4% on the original liability. Term structure risk also occurs with floating rate assets or liabilities. If fixed rate assets are financed with floating rate liabilities, the rate payable on the liabilities may rise while the rate earned on the assets remains constant.

In general, any occasion on which interest rates are to be reset—either due to maturities or floating rate resets—is called arepricing. The date on which it occurs is called the repricing date. It is this terminology that motivates the alternative name "repricing risk" for tem structure risk.

If a portfolio has assets repricing earlier than liabilities, it is said to be asset sensitive. This is because near term changes in earnings are going to be driven by interest rate resets on those assets. Similarly, if liabilities reprice earlier, earnings are more exposed to interest rate resets on those liability, and the portfolio is called liability sensitive.For example, a bank that is supporting fixed rate liabilities with floating rate assets is asset sensitive. Earnings risk is posed by the floating rate on the assets. This example is only meaningful from a book value standpoint—which focuses on earnings risk. From a market risk standpoint, the floating rate assets pose little risk—floaters have stable market values. It is the long-dated liabilities that pose market risk. Their market values fluctuate with changes in long-term interest rates. From the economic perspective, it would be reasonable to call the bank "liability sensitive!" Of course, that is not how the terminology is used. However, our example highlights how fundamentally different the book-value and market-value perspectives are.

It should be emphasized that this discussion uses the terms "asset" and ":liability" loosely, and not in any strict accounting sense. We include among assets and liabilities both derivatives and other off-balance sheet instruments that may behave like assets or liabilities. A pay-fixed interest rate swap might be considered a combination of a floating rate asset with a fixed rate liability. On a stand-alone basis, it poses considerable term structure risk.

Basis risk is risk due to possible changes in spreads. In fixed income markets, basis risk arises form changes in the relationship between interest rates for different market sectors. If a bank makes loans at prime while financing those loans atLibor, it is exposed to the risk that the spread between prime and Libor may narrow. If a portfolio holds junk bondshedged with short Treasury futures, it is exposed to basis risk due to possible changes in the yield spread of junk bonds over Treasuries.  Basis risk is another name for spread risk.

As with term structure risk, book-value and market-value perspectives differ with respect to basis risk. As always, the book value perspective focuses on risk to earnings. If the spread between interest earned on assets and interest paid on liabilities narrows, those earnings will suffer. The economic perspective considers the risk to the portfolio's market value. If a spread narrows or widens, the market values of assets and liabilities may be affected differently—and the net market value of the overall portfolio could suffer.Options risk, as a component of interest rate risk, is risk due to fixed income options—options that have fixed income instruments or interest rates as underliers. Options may be stand-alone, such as caps or swaptions. They may also be embedded, as with the call feature of callable bonds or the prepayment of mortgage-baked securities (MBS). In some respects, options risk is just another component of term structure risk. This argument needs to be explored differently for the book value and market value perspectives.

From the book value perspective, the distinction between term structure and options risk has historical roots. Payoffs of options depends upon changes in interest rates, which would seem to make options one more source of term structure risk. However, by shorting embedded options, a depository institution can enhance short-term earnings at the expense of long-term earnings. This is what happened during the 1980s, when the MBS market was just emerging. Dealers found US thrifts and other depository institutions to be eager buyers of MBSs. Because of their short embedded prepayment options, the MBSs offered very high yields—and those high yields flowed immediately to earnings. Because MBS pricing was far from transparent, dealers could charge exorbitant prices for the MBS—they priced them to have yields much higher than Treasury notes, but not high enough to fully compensate for the short options. From an economic standpoint, thrifts incurred a loss every time they purchased an MBS, but the thrifts didn't see that. Perceiving the world from a purely book-value/earnings perspective, all they saw was an immediate jump in earnings. Only later, when interest rates dropped and prepayments on the MBS surged, did the thrifts realize their mistake. Loses were staggering and were a primary contributor to the ensuing crisis in the US thrift industry.

Part of the thrifts' problem was due to being cheated by the dealers who sold them the MBS at inflated prices. That is a risk distinct from interest rate risk. It is as old as Wall Street—caveat emptor. However, another significant issue was the emerging problem that derivatives and new structures with embedded options made it possible to do an "end-run" around traditional book value accounting. Increasingly, earnings could be manipulated for the short-term, with consequences pushed into the future. Traditional techniques of asset-liability management—which focused on term structure and basis risk—were ill equipped to address this emerging risk. Hence, the new risk was given a name—options risk—and managers came under pressure to supplement old tools with new ones that could assess this new risk.

The economic perspective on options risk is very different. From that standpoint, options pose immediate risk in the form of changes in their market value. While shorting embedded options can generate income that immediately flows to earnings, it does nothing for market value—the option premiums are offset by the negative market value of the newly shorted options. If the options are shorted at fair prices, the two cancel—and there is no immediate market value impact.