30 Oct 2013
Interest rate risk is the risk that the relative value of an interest-bearing asset, such as a loan or a bond, will worsen due to an interest rate increase. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa. Interest rate risk is commonly measured by the bond’s duration, a technique used to manage interest rate risk exposure.
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. Marking to market, calculating the net market value of the assets and liabilities.
2. Stress testing the market value by shifting the yield curve in a specific way. Duration is a stress test where the yield curve shift is parallel.
3. Calculating the Value at Risk (VaR) of the portfolio.
4. Calculating the multiperiod cash flow or financial accrual income and expense for N periods forward in a deterministic set of future yield curves.
5. Measuring the mismatch of the interest sensitivity gap of assets and liabilities, by classifying each asset and liability by the timing of interest rate reset or maturity, whichever comes first.
Credit risk is the risk of loss due to a debtor’s non-payment of a loan or other line of credit, either the principal or interest or both. The higher the perceived risk the more spread over a risk free rate will be required. A recent innovation to protect lenders and bond holders from the danger of default are credit derivatives, most commonly in the form of a credit default swap. These financial contracts allow users to buy protection against defaults from a third party, the protection seller. The protection seller receives a periodic fee (the credit spread) as compensation for the risk it takes and in return, it agrees to buy the debt at the defaulted market price, should a credit event (“default”) occur.
Liquidity risk arises from situations in which a party interested in trading an asset cannot do so because there is no counterparty willing to purchase the asset. Liquidity risk becomes significant during times of market distress, since it affects the ability to execute trades with immediacy, depth and resilience.
This risk is very different from a significant drop in price. A fall to a price of zero is saying that the asset is worthless. Liquidity risk is usually found more often in emerging markets or low-volume markets. Liquidity is one of the most unstable and difficult to measure risk parameters.