A refresher on interest rate risk
Introduction
Interest rate risk is one of the key financial risks, and a common risk type we face every day. Mortgages are one of the most common areas that many people will face interest rate risks, given the high housing prices in Hong Kong. When we enter a HIBOR mortgage plan, our monthly instalments are linked to changes in the Hong Kong Interbank Offered Rate (HIBOR), and will change in line with changes in the HIBOR.
Moreover, we often hear people say the interest rate risk is higher, but what exactly does it mean? Does it refer to long-term tenors or short-term tenors?
Interest rate risk is not as simple as we think it is. Hopefully by going through a few key components below, namely, risk identification, risk measurement and risk control, we can have a better understanding of interest rate risk.
1. Risk identification
Yield curve risk
Yield curves track the interest rates for different maturities. Interest rate risk is not always simply caused by parallel movement up or down of the yield curve. Given that yield curves track different tenors, an increase in the interest rate can affect the HIBOR of different term structures (e.g. 1-month and 3-month) differently.
In short, there are two types of yield curve changes, parallel shifts and non-parallel shifts.
A parallel shift represents a change to the interest rate at each tenor that is of the same magnitude. It is the most straightforward scenario, but seldom happens in reality. A non-parallel shift is the opposite. Different tenors can have different interest rate changes. For example, short rates can go down while long rates go up, or short rates go up and long rates down. A non-parallel shift of the yield curves can have different impacts to the fair value depending on the cash flow and discount rate at each tenor of the products.
Basis risk
Basis risk is a risk caused by the imperfect correlation between changes in rates earned and rates charged. While they are of the same repricing, their changes in rate cannot be fully offset and potential interest rate residual risk results. This is due to the fact that the two underlying curves of the rates do not perfectly correlate.
Assuming we have a 3M-HIBOR mortgage but our funding is at 3M-LIBOR, which is the benchmark used in the international interbank market, when there is non-perfect correlation in the market between HIBOR and LIBOR, some small basis risk may exist at that situation even though they are both of 3-month tenor. In fact, varying levels of basis risk accompany different interest rate indices. It is therefore important to study the correlation between the interest rate indices to identify the corresponding risk level.
Option risk
An option risk arises when a lender or borrower can change the level or timing of the interest cash flow. Knowing the underlying option risk will allow us to understand as investors whether there is any corresponding opportunity or benefit.
For example, a floating rate mortgage can create uncertainty due to changes in the future interest rate. Those who prefer certainty may believe a fixed rate mortgage, where the interest rate is set for a set period. Nonetheless, fixed rate mortgages have their own risk in that when market interest rate is relatively lower than the fixed interest rate, the borrower may be locked into paying a less favourable interest rate.
In addition, a fixed rate mortgage may have option risk for the lender. This happens when a borrower chooses to enter into a new deal with a lower market rate and repay the original mortgage, provided that a lender allows early repayment. Unlike the previous cases where the borrower suffers from the interest rate risk, the option risk in this case is borne by the lender as it gives the borrower a right to repay.
An embedded option risk does not necessarily belong to asset class; it applies also to the liability class. For example, in the case where a lender has placed a term deposit for a fixed interest rate, he may choose to withdraw the term deposit to enter into a new deal before the maturity date if the market interest rate is comparatively more favourable. In this case, the borrower will bear the embedded option risk as the lender has a right to break early.
In reality there are various constraints for early break or prepayment. For instance, there can be a lock-up period, penalties for early break or repayment imposed.
2. Risk measurement
There are two common dimensions for evaluating interest rate risk exposure, namely, net interest income perspective and economic value.
The net interest income perspective is more straightforward. The perspective refers to how much more or less net interest income we will obtain due to the interest rate changes to our net interest bearing assets (that is, interest bearing assets less interest bearing liabilities). The net interest income perspective focuses on changes to future profitability within a timeframe due to the interest rate movement.
Economic value focuses on the changes to net present value of the underlying asset due to the interest rate movement. In simple terms, the economic value is similar to calculating the discounted cash flow, taking into consideration the changes of denominator (i.e. the discount rate)
Take a fixed rate 5-year bond as an example. With a fixed coupon, it appears the interest income we gain from the bond will be fixed and have no interest rate risk. However, if interest rate goes up, the discount rate will increase, the fair value of the fixed rate bond will normally drop, leading to mark-to-market losses.
3. Risk control
One of the risk control measures for interest rate risk is hedging. Given the variety of hedging methods, this article only focuses on a few of the major ones.
When it comes to hedging, using financial derivative like an interest rate swap come to mind easily. What about natural hedge? One of the products which offers a similar opportunity is a deposit-linked mortgage product where the savings interest rate will be matched with the mortgage interest rate for part of the deposit with the bank. There are usually certain conditions imposed by the bank on a deposit-linked mortgage, for instance, the amount of savings deposit that enjoys the mortgage interest rate.
Imagine if we applied for a HK$3 million mortgage loan at an interest rate of 2.2% p.a., and we were allowed to deposit up to HK$1.5 million with the bank which will offer a deposit interest rate equivalent to that of a mortgage interest rate (i.e. 2.2% p.a.). The covered portion of 1.5 million can be considered to be naturally hedged, in that even though if in the future the mortgage interest rate increases to 2.3%, the corresponding deposit interest rate will also increase to 2.3%.
To better manage some more complex type of interest rate risk like the option risk, some behavioural modelling techniques may be required. Regular reviews and adjustments of the model and assumptions will be necessary for the enhancement of model performance.
Recent regulatory reform
Interest rate risk is highly relevant to our daily lives and indeed there have been some regulatory reforms in the past few years.
“Basel III” is a familiar term for regulatory reforms. When it comes to Basel III, many people can readily recall some key reforms on liquidity such as “Liquidity Coverage Ratio” and “Net Stable Funding Ratio”. In addition, the Basel Committee on Banking Supervision issued revised standards for interest rate risk in the banking book in 2016note 1. Some key enhancements to the initial 2004 Principles include:
- Providing more detailed guidance and clearer requirements for interest rate risk in the banking book management
- Enhancing disclosure for interest rate risk in the banking book
- Providing an enhanced standardized framework with six interest rate shock scenarios
Key takeaways
Interest rate risk management is becoming increasingly important, not only because the interest rate environment is so dynamic, but it also keeps evolving which has bearing on topics like LIBOR-reform and negative interest rate. To assess the interest rate risk level and corresponding management technique, careful considerations should be given to risk identification, risk measurement and risk control. The more we understand the risk we are exposed to, the better we can manage it and hopefully this refresher is a good starting point.
Footnotes
1. Bis.org/bcbs/publ/d368.pdf
About the author
Isaac Cheng
Head of L2 Regulatory Controller, Asia Pacific, Societe Generale
A public limited company incorporated in France
