BAS Case Study - March 2023

APPENDIX A - DEFINITION AND TYPES OF INTEREST RATE RISK

Interest Rate Risk: The exposure of a bank’s current or future earnings and capital to interest rate changes.

Five Types of Interest Rate Risk: 1. Repricing Risk (timing differences): Reflects the possibility that assets and liabilities will reprice at different times. For example, management may use non-maturity deposits to fund long-term, fixed-rate securities. If interest rates rise, there will be upward pressure on deposit rates, and no change in the yield on longer-term securities. 2. Basis Risk (different indices): Risk that different market indices will not move in perfect or predictable correlation. For example, LIBOR-based deposit rates may change by 50 basis points while prime-based loan rates may only change by 25 basis points during the same period. 3. Yield Curve Risk (similar index, different maturities): Reflects exposure to unanticipated changes in the shape or slope of the yield curve (e.g. flattening or steepening). It occurs when assets and funding sources are linked to similar indices with different maturities. For example, the cost of short-term borrowings could increase more than the yield on longer term assets if the yield curve flattens. Or the yield on short-term assets could increase less than cost of longer-term liabilities if the yield curve steepens. 4. Option Risk: Risk that a financial instrument’s cash flows can change at the exercise of the option holder, who may be motivated to do so by changes in market interest rates. The exercise of options can adversely affect the net interest margin by reducing asset yields or increasing funding costs. For example, when callable bonds are called, the investor is forced to reinvest the proceeds in a lower yielding environment.

5. Price Risk: Reflects volatility of asset market values (i.e. bonds) with changes in interest rates.

For example, when interest rates rise, bond values decline.