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Interest Rate Risk Management Importance A Level English Language Essay Help

Table of Contents
Introduction The Reasons behind IRR The Effects of Internal Rate of Return on Financial Institutions The Evaluation and Administration of IRR by Financial Institutions How GAP and Financial Derivatives Are Related The Pros and Cons of GAP and Financial Derivatives in the Workplace Conclusion Bibliography


Since the end of the financial crisis, the global banking sector has experienced heightened interest rate risk (IRR). The IRR is currently close to pre-recession levels, necessitating the incorporation of appropriate steps to ease the situation. The issue primarily impacts smaller banks within the business, as opposed to the larger banks. Focusing on areas such as the competitiveness of the environment, products, and services, it is essential to address the factors that contribute to the industry's rising IRR. As a result, the quantification and management of interest rate risks are seen as essential facets of bank managers' responsibilities in the present day. In this regard, it is vital to understand the causes of IRR, its effects on financial institutions, and/or how financial institutions manage and calculate IRR by researching the appropriate literature.

The Reasons behind IRR

Chan-Lau, Liu, and Schmittmann (2015) state that IRR has a significant impact on the financial health of banks. Therefore, it is essential to investigate the factors that influence interest rate changes, which pose a significant danger to the capital base and earnings of banks. Multiple factors subject the financial system to IRR. According to the Federal Housing Finance Agency (2013), the significant drivers of IRR are "repricing risk, yield curve risk, basis risk, and optionality" (p. 1). According to Sharifi, Saeidi, and Saeidi (2014), repricing risk is one of the most important sources of IRR in the banking industry. According to Aspal and Nazneen (2014), the formation of IRR is due to timing fluctuations related with the maturity and repricing of financial institutions' liabilities, assets, and off-balance-sheet (OBS) positions. Inconsistent pricing is a fundamental aspect of the banking industry. According to the Basel Committee on Banking Supervision (2004), such disparities can expose financial institutions to unfavorable returns and impact the institutions' economic value, particularly when income rates fluctuate (Bessis, 2015). In this view, if the interest rate rises, banks that use short-term deposits to support a long-term fixed-rate loan may experience a decrease in revenue and economic value. Consequently, mismatches in repricing represent a significant threat to the financial viability of commercial banks when interest rates fluctuate, as Aspal and Nazneen (2014) demonstrate.

Variations in pricing have the potential to expose financial institutions to variances in the slope and shape of the productivity curve. According to Aspal and Nazneen (2014), the threat posed by the productivity curve activates IRR in a manner that affects the financial standing of banking institutions. Notably, unforeseen yield curve shifts harm the economic worth and profitability of banks. In the majority of instances, investments in fixed instruments may expose banks to unfavorable interest rates, so diminishing their income levels. Alessandri and Nelson (2015) assert that market yield changes have substantial effects on the price of a particular fixed-income instrument. Due to the increase in market rates, the price of a bond in which a particular bank has invested may decline. As a result, yield curve risk is a significant source of IRR in the banking industry, as it influences the values of fixed-income instruments such as bonds.

According to Bessis (2015), the banking system's IRR is also significantly affected by the base risk. The determination of the basis risk is depicted in Fig. 1.

Figure 1. Basis Risk.

The source: (Bessis, 2015).

Particularly, the appearance of basis risk results from any imperfect modification of the rates earned and paid on distinct instruments with otherwise equal repricing characteristics. Consequently, interest rate swings may result in unanticipated currency movement variations and income spread in relation to obligations, assets, and Off-Balance Sheet instruments. It is essential to note that these instruments have the same repricing frequencies. If banks use various methods to calculate the interest earned in each region of the balance sheet, they are susceptible to basis risk, which reduces the final interest yields (Alessandri & Nelson, 2015). According to this perspective, the fundamental risk is also an essential IRR trigger in the banking industry.

Esposito, Nobili, and Ropele (2015) reveal a variety of underlying possibilities for financial industry liabilities, assets, and OBS instruments. In a formal sense, Esposito et al. (2015) explain that optionality provides the owner with the right, as opposed to the responsibility, to purchase, sale, or change the cash flow of a certain instrument or financial agreement. Notably, options can take the shape of distinct instruments, such as OTC and exchange-traded options. In addition, options may be incorporated into standard instruments. In this regard, securities having underlying options, such as bonds and notes, give their respective holders the freedom to conduct transactions as they see fit. As a result, the flexibility provided to depositors encourages them to make withdrawals at any time. Therefore, options have the potential to undermine banks' profitability.

The Effects of Internal Rate of Return on Financial Institutions

As stated previously, the IRR issue has undeniable consequences on the income and economic worth of financial organizations. In this regard, the two negative implications of the IRR problem in the financial industry provide two unique but complimentary perspectives on evaluating banks' IRR vulnerability. Therefore, it is essential to determine the extent to which the IRR problem weakens the earnings and value of banking organizations.

Interest rate disparities in the financial business have a major impact on the accumulated earnings of the parties involved. According to Bessis (2015), many financial organizations tackle the element of monetary risk management by analyzing the impact of interest rate variations on annual earnings. According to Bloom (2014), managers of financial institutions view outright losses or a reduction in earnings as a problem that is directly influenced by dramatic interest rate movements. The IRR issue is taken into account by risk managers since it leads to the insufficiency of capital and undermines market confidence. In this regard, reduced earnings resulting from IRR have a negative impact on the financial stability of banks.

One of the key areas affected by the IRR issue in the banking sector is the net interest income. According to Chan-Lau et al. (2015), the difference between the ultimate interest returns and the cumulative interest fees may be influenced by IRR. Notable, the majority of banks realize their accumulated revenues via net interest income. Consequently, such net interest income is an essential element of profitability. However, financial institutions expand their operations to include fee-generating activities and other products and services that earn non-interest profits. Surprisingly, the unpredictability of interest charges in the market also affects non-interest income activities, indicating the extent to which IRR influences the expected earnings of financial institutions. Currently, transaction-processing fee revenue is likewise susceptible to the fluctuation of interest rates. This indicates that non-interest returns are similarly affected by changes in the prevalent interest rates (Esposito et al., 2015). Variable interest rate settings have a significant effect on the profits of financial organizations.

IRR also has a substantial impact on the portfolios that define the economic value of financial institutions. According to Jiménez, Lopez, and Saurina (2013), the instability of interest rates influences the monetary value of a financial institution's liabilities, assets, and Off-Balance Sheet instruments. Therefore, supervisors, managers, and shareholders view the change of current interest rates as a significant factor, since it impacts the financial value of financial institutions. Notably, according to Jokipii and Monnin (2013), the economic significance of a financial institution is a reflection of a bank's anticipated cash flows. Due to the fact that material products, expenses, and OBS conditions affect the cash flow of a financial institution, it is crucial for the market to set stable interest rates, since they influence the aforementioned factors.

Notably, the value of a financial institution can be determined by determining the difference between the predicted cash flows on expenses and the probable currency movement on resources, and then adding this difference to the projected net cash flow achieved from the company's OBS holdings (Bloom, 2014). According to this idea, differences in interest rates have a substantial impact on the currency fluctuations of financial organizations. According to Taiwo and Adesola (2013), the impact is significant since it affects the true value of the financial institution. For the purpose of enhancing the economic significance of a particular commercial bank, shareholders, supervisors, and managers must consistently engage in effective and efficient risk management techniques.

In accordance with Jiménez et al. (2013), the IRR issue compels managers, supervisors, and shareholders to evaluate the influence of past interest rate variations on the current financial performance of a given financial institution. In this regard, IRR involves the study of past and present interest rate unpredictability in order to obtain a picture of the current and prospective financial position of the banking system. In addition, instruments unrelated to market interest rates show gains or losses due to previous and current interest rate swings, indicating the impact of IRR on a bank's net worth (Taiwo & Adesola, 2013). Therefore, the issue of IRR is crucial for analyzing the financial performance of numerous and diverse banking industry participants.

The Evaluation and Administration of IRR by Financial Institutions

Financial organizations may utilize a variety of IRR management strategies. The measurement of IRR is typically the initial step in problem management. According to Beets (2004), banks can include either the GAP analysis or financial derivatives to facilitate the assessment and management of IRR. The two approaches measure and manage IRR in the banking sector using distinct methodologies.

How Financial Derivatives and GAP Operate

GAP analysis comprises a consistent review of threats that are linked to the targeted net interest returns (margin). According to Koch and MacDonald (2014), GAP analysis focuses on determining the discrepancy between the value of assets and liabilities on which interest rates fluctuate within a certain period. In this instance, the GAP analysis supports the evaluation of IRR using an asset-liability management strategy (Van Deventer, Imai, & Mesler, 2013). The simplicity of the measurement method reveals the variation between assets and liabilities over a specific time period that is sensitive to interest rate volatility.

According to Beets (2004), one of the more modern approaches for evaluating and managing IRR in the banking industry is the use of financial derivatives. Specifically, financial derivatives are instruments whose value is derived from one or more underlying financial assets (Chance & Brooks, 2015). The underlying instruments may be a securities index, a financial security, an integration of securities and indices, or commodities (Hull & Basu, 2016). Notably, options, futures, forwards, and swaps are among their many forms.

Comparing the Pros and Cons of GAP and Financial Derivatives

According to Hull and Basu (2016), the classic GAP analysis IRR measuring approach is helpful since it enables banks to compare the present or actual net interest income performance with the desired performance. In accordance with the findings of Sharifi et al. (2014), an asset-sensitive "gap" indicates that the bank's assets exceed its liabilities within a specific time period. This result demonstrates the success of the net interest income of the financial organization. Koch and MacDonald (2014), on the other hand, suggest that the detection of a liability-sensitive "gap" indicates that a financial institution may generate undesirable net interest returns.

However, the GAP analysis is unfavorable because it disregards variations in interest rate spreads that may come from market volatility. Moreover, according to Van Deventer et al. (2013), the IRR calculation approach does not account for the optionality of assets and liabilities. In addition, the repricing assumptions used to non-maturity deposits undercut the dependability of this IRR management strategy.

Forward contracts are legally binding agreements between parties to buy or sell government securities, a defined quantity of a commodity, or foreign currency in addition to other financial instruments at a specified price, with delivery and settlement expected at a specified time (Chance & Brooks, 2015). Futures contracts share comparable qualities with forwards, but this category is advantageous because it subjects contracting parties to a lower level of risk than the former does. Combining futures rate agreements (FRAs), interest rate swaps allow counterparties to exchange the collection of future cash flows (Saunders, 2014). In order to facilitate interest rate control, options provide underlying security in the form of a debt obligation (Bingham & Kiesel, 2013). Options also provide protection against variable-rate loans, so lessening the negative consequences of interest rate swings. The aforementioned financial derivatives aid banks in calculating and managing IRR via hedging (Bingham & Kiesel, 2013). These derivatives may be utilized in a variety of circumstances to ensure that financial institutions attain desirable profits and the economic value of their instruments (Hull & Basu, 2016). However, they are unfavourable because they require banks to pay money or premiums in order to use the instruments to facilitate the measurement and management of IRR.


IRR is a significant issue that poses a threat to the operations of modern banking systems due to the exceptional volatility of market interest rates. In addition to the repricing of liabilities, assets, and OBS, the optionality of financial instruments also contributes to interest rate changes. Consequently, IRR influences the accrual earnings and economic value of financial organizations. This circumstance illustrates the effect of interest rate volatility on the performance of market participants. As a result, financial institutions employ techniques such as the GAP analysis and derivatives to assist the assessment and management of IRR.


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