There are a number of standard calculations for measuring the impact of changing interest rates on a portfolio consisting of various assets and liabilities. The most common techniques include:
1. Basis risk is the risk presented when yields on assets and costs on liabilities are based on different bases, such as the London Interbank Offered Rate (LIBOR) versus the U.S. prime rate. In some circumstances different bases will move at different rates or in different directions, which can cause erratic changes in revenues and expenses.
2. Yield curve risk is the risk presented by differences between short-term and long-term interest rates. Short-term rates are normally lower than long-term rates, and banks earn profits by borrowing short-term money (at lower rates) and investing in long-term assets (at higher rates). But the relationship between short-term and long-term rates can shift quickly and dramatically, which can cause erratic changes in revenues and expenses.
3. Repricing risk is the risk presented by assets and liabilities that reprice at different times and rates. For instance, a loan with a variable rate will generate more interest income when rates rise and less interest income when rates fall. If the loan is funded with fixed rated deposits, the bank's interest margin will fluctuate.
4. Option risk is presented by optionality that is embedded in some assets and liabilities. For instance, mortgage loans present significant option risk due to prepayment speeds that change dramatically when interest rates rise and fall. Falling interest rates will cause many borrowers to refinance and repay their loans, leaving the bank with uninvested cash when interest rates have declined. Alternately, rising interest rates cause mortgage borrowers to repay slower, leaving the bank with relatively more loans based on prior, lower interest rates. Option risk is difficult to measure and control.
Prime interest Rate Reduction Narrows The Interest Rate Gap Between Israel And Abroad.(Brief Article)(Statistical Data Included)
Oct 01, 2000; Lower inflation (which has almost been rung out the economy) in Israel and sluggish demand allowed Israel's central bank to lower...