BAS September 2022 Presentations

APPENDIX A - DEFINITION AND TYPES OF INTEREST RATE RISK A PENDIX A: Definition and Types of Interest Rate Risk

Interest rate risk is the potential that a bank’s earnings and capital could  be negatively impacted by changes in interest rates. 

Five Specific 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.