Interest Rate Risk

1
Interest Rate Risk

• Involves the likelihood (probability) and
  severity (size) of losses associated with
  unanticipated changes in interest rates.
• Discount rates change
• PV effect rising rates implies falling values
• Contractual cash flows
• ARMs, caps/floors, etc.
• Embedded options
• Prepayment, callables, etc.
• Interplay between assets and liabilities
• Which side of the balance sheet is more
  vulnerable?

2
Interest Rates

• Volatility
• Predictability
• Cant rule it out
• Let me know if you know how to do it!
• Market rates vs. administered rates
• Market rates are yields on traded securities
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• Real rate
• Inflation premium
• Maturity premium
• Default premium
• Liquidity premium
• Option premium (or discount?)

3
Interest Rate Theories

• Pure Expectations Theory
• Implied forward curve best estimate
• Can be rejected empirically with high level of
  confidence
• Liquidity Preference Theory
• Existence of a maturity premium
• Probably true, but the premium changes over time,
  too
• Preferred Habitat Theory
• Difference investors inhabit difference
  maturity areas of the market

4
Concerns for Risk Managers

• Level of Interest Rates
• Usually the short-term (3-month?) T-bill yield
• Slope of the yield curve
• Often the difference between the 10-year and
  3-month T-bill yields
• Volatility
• An expectation about the future
• Implied volatility from option prices
• Other issues
• Credit spreads
• Liquidity spreads