Risk exposures: The Financial Transaction Risks Table
Features of the method used to measure the interest rate identified
Before determining the best method to be used in the measurement of the interest risk, it is essential to assess the source of the risk. The most common sources of interest rate risk are security mismatching for various items in the balance sheet depending on whether the interest rate is fixed or variable. The value assets lead to interest rate risk when there are valuation problems as well as in situations where interest rates are not aligned with the liabilities and assets (Kaufman, 1984).
Various methods are applicable in measuring the risk of interest rate. The complexity of the method and the degree of sophistication varies (Kaufman, 1984). The sensitivity of the assets to market interest rate is one of the features that characterize the methods of estimating the risk posed by the rate of interests. The level of sensitivity of the rate of interests to the values of liabilities, assets, and other items defined outside the balance sheet helps in carrying out the gap analysis to evaluate the effects of interest rates on the financial cash flows.
Changes may occur in the prices of the borrowing instruments such as bonds, and the interest rate must be adjusted accordingly (Doff, 2008). When these changes occur, it becomes necessary to capture the convex relationship in order to estimate the risk posed by significant changes in the rate of interest. Convexity is a characteristic feature of PVBP (price value of a basis point) method of measuring the extent of interest risk. This method is commonly used to determine the risk posed by changes in interest rate due to variations in prices of borrowing instruments (Doff, 2008). The prices of the instruments are compared using different interest rates to estimate the impacts.
On the line of security prices variations, price volatility becomes an important feature that aids the estimation of the risk of variations in interest rates. When the security prices exceed the returns, interest rates must be adjusted to capture the price change (Yuan, Tan, & Li, 2009). For example, the insurance company that invested its premiums in long-term bonds stands a great risk of loss due to variations in interest rates to accommodate changes in the bond prices. Because bonds are paid upon the maturity of the agreed period, if the bond prices reduce, the interest rates will have to be reduced, implying that the investor will lose. Another case is where a bank uses the proceedings from the sale of CD (certificate of deposit) to finance its debt. In this example, the difference in interest rates is the main feature of the method that could be used to estimate the risk. The CD (certificate of deposit ) used to borrow the money attracts a fixed interest rates while the interest rate on the long-term loan the investor is financing may be variable. If the interest rates on the loan increase beyond the returns from investment, the investor will end up paying more than what he gains, resulting in financial loss. Another feature that could be prominent in the methods of determining the extent of interest rate risk is the simulation of rates of interest as the assets’ value, liabilities, and other items changes. Lenders tend to adjust the interest rates when there are dynamic simulations in the development of assets (Yuan, Tan, & Li, 2009). For example, when the security prices rise, lenders will have to simulate the interest rates to minimize the risk of financial loss.
The insurance company which invested its premiums on long-term bonds will suffer financial loss if the expected simulations in interest rate are not realized. The speculation power of the investor will have failed. Therefore, it can be concluded that variations in interest rates are crucial considerations that investors should make before making any investment decision. Interest rates have significant exposure to financial loss, and therefore investors should carry out comprehensive analysis to determine the investment decisions that are less risky. A careful risk management is essential for individual investors and the government for efficient economic development.
References
Doff, R. (2008). Defining and measuring business risk in an economic-capital framework. The Journal of Risk Finance, 9(4), 317-333.
Kaufman, G. G. (1984). Measuring and managing interest rate risk: a primer.Economic Perspectives, 8(1), 16-29.
Yuan, Y., Tan, S., & Li, D. (2009). Risk Identification and Evaluation in Trade Finance Innovation of Commercial Banks. International Journal of Business and Management, 3(9), 40.
