Risk Measurement and Management: interest rate, liquidity and operational risk - Essay Example

It affects the value of bonds directly as compared to stocks thus a major risk to all bond holders. The increase in interest rate reduces the bond prices while their decrease inflates the bond prices. Therefore, as interest rate increase, the cost of holding a bond reduces because investor are able to recognize grater yields by opting to other investments that result into high interest rates(Allen, 2004). Interests’ rate risk may emerge as a result of basis risk, yield curve risk, repricing risks and optionality. Measurement These are instruments that help in detecting the level of interest rates to show how the risk can be managed effectively. These measurement tools involve repricing, maturity and duration models. The repricing model This model is also known as the funding gap model whereby a book worth accounting cash flow scrutiny of the repricing gap between the interests revenue gained on assets and the interest spent on liabilities over specific duration. Repricing gap is the variance amid the rate sensitive assets and liabilities (Ahmed, Beatty & Bettinghaus, 2004). Repricing model therefore, illustrates for example how a bank calculates the gaps in each basket by looking at the level of sensitivity of each asset and liability also known as time pricing. Repricing model is shown below: =?NIIi = (GAPi) ?Ri = (RSAi - RSLi) ?Ri (this applies to any i bucket) Weaknesses The repricing model does not show the true exposure of the market value effects thus affecting in the determination of the rate of risk. There is over aggregation whereby there is a mismatch within the buckets (Davidson, 2001).Liabilities may be repriced at diverse times than assets in one basket. Finally, runoffs are experienced by this model whereby there are periodic cash flows on principal and interest amortization payments on long term assets like conventional mortgages that can invested again at the market rates. The maturity model This model involves the market value of accounting whereby the assets and liabilities are revalued as per the current level of interest rates. This is actually shows how changes in interest rates influence the value of bonds, for instance: 1year bond, 10%coupon, $100 face value=10% In this case if the sales at par is worth $100, then if the rate of interest rise to 11% then the value of the bond would reduce to $99.10 resulting into a capital loss of $0.90per $100.Consequenlty, it is noted that interest rates reduce the market charges of both assets and liabilities of an F1.If the bond is within a period of 2 yeas then: At R=10%, sells at per At R=11%, principal=98.29 dollars Whereby the capital loss would be $(98.29-100) = -1.71%.Hence,when the maturity of a fixed asset or liability prolongs then there is a greater fall in price and market value for any given rise in the level of interest rates. When this model is considered with a portfolio of assets and liabilities then there will be a tragic situation especially if the bank encounters an extreme asset liability mismatch. This is also encountered in the case of deep discount that is zero coupon bonds where the problem is extreme and disastrous implications emerge. For instance,1% increase in interest rate, minimizes the value of the 10 years bond by -23.73 per $100 hence showing a completely and massive insolvency (Brennan & Schwartz, 1979). Therefore, maturity matching and interests rates exposure does not result into a good measurement criterion since it does not ...Show more