Wide swings in market interest rates have brought the issue of the managing interest rate risk into sharp focus. Techniques have been developed to reduce interest rate risk, or at least transfer it to speculation who are willing to deal with it in hop...
Wide swings in market interest rates have brought the issue of the managing interest rate risk into sharp focus. Techniques have been developed to reduce interest rate risk, or at least transfer it to speculation who are willing to deal with it in hopes of making or profit. In Korea, the financial institution are confronted by the many managerial problems which are related with international aspects and internal control especially interest fields. In this point of view, techniques for managing interest rate risk are presented and discussed in this article.
Interest is the price paid for the use of credit, and the price contains two components-a real rate of interest rate and inflation premium. Of course there are many kinds of interest rate, such as single interest rate, compound interest rate and discount, etc . And it is very difficult to deal the unisonant transaction, because there are difference in interest rate risk and term structures.
The process of interest rate decision is very complicated. The nominal rate of interest is the real rate of interest plus an inflation premium. The inflation premium represents the change in price levels during the period when the funds are borrowed. There are many theories developed for the interest determination. However, three theories are selected to simplify the discussion points. They are Unbiased Expections Theory, Liquidity Premium Theory and Market Segmentation Theory.
In this article six technical points of view for the interest risk management are discussed. They are duration, financial futures market, hedging, layering strategy, option and gap management.
Duration is a concept first introduced by Frederick Macaulay to provide more complicate summary information about the term structure of a bond than term to maturity. Because maturity provides information only about the date of final payments. Duration views a conventional non zero coupon bond as a zero coupon serial bond with consecutive maturity payments equal to the coupon payments plus a larger payment at final maturity. In calculating duration, it is the weighted average time to receive all reflect (or dividends) and principal where the weights reflect the relative present values of the cash flows. We can understand two points of view for the duration, which are performance and immunization.
The futures market developed i n the United States, because buyers and sellers of grains were affected by seasonal surpluses and shortages that caused wide price fluctuations and risk. In general the participants in the futures market consist of hedgers, speculators and the commodity exchange community.
Interest rate risk is difficult to eliminate for many financial institutions. Hedging-matching the maturities of assets and liabilities- is one method of eliminating interest rate risk. There are two kinds of hedgings. One is hedging against falling interest rate (Long Hedge) and the other is hedging against rising interest rates (Short Hedge). Layering strategy is to avoid the interest risk fluctuation with the comparing the assets and liabilities according to term structure in financial institutions. In balance sheet net exposed balance is calculated through the asset and liability items. The incomparable part should be managed by the future markets.
Two basic types of option are used to buy and sell securities-calls and puts. Until recently, option trading had been confined to stocks. A call option is contract to buy an asset at predeterminded price on or before a certain date. The buyer of the option pays the seller a fee, called a premium, for the contract. A put option is a contract to sell an asset at predeterminded price on or before a certain date. The buyer of the put option pays a premium to seller of the option, just like calls. There are many option strateges, too.
Gap management model is used to hedge net interest income against charges in interest rates for the banks net interest income management. On the other hand, the bank adopts an actives strategy, an interest rate forcast for the gapping period is required. Anyway it is a great view to shrink the difference of the dollar amounts between rate-sensitive assets and rate-sensitive liabilities.
This paper began by reviewing the interest rate and term structure. Interest rate risk can be expected always whenever the investment performs. It should be treated with the scientific approach. The techniques which are introduced in this paper is not common in Korea even though they are spreading in every institutions in developed countries. It is clear that the development of financial techniques is the key role for the financial autonomy.