Management Notes

Reference Notes for Management

Interest Rate Risk – Risks in Commercial Banks | Financial Management

Interest Rate Risk

Interest rate risk is another type of risk that must be managed. A rise in interest rates may cause a commercial bank’s liabilities to exceed its assets by an unexpected amount. Essentially, this risk arises from the relationship between the interest rate on assets (return) and the interest costs or charges on liabilities. The spread between these rates directly affects the profitability of a commercial bank. The goal of commercial banks is to have a wide spread in which the return on assets exceeds the cost of liabilities.

When the cost of liabilities exceeds the return on assets, a positive spread today can turn into a negative spread. As a result of this changing environment, commercial banks have adapted in a variety of ways, including becoming more aggressive in utilizing financial futures, options, and swaps. Nowadays, these instruments are widely used to reduce interest rate risk.

Because the present value of return from investment moves inversely with market interest rate, fluctuation in market interest rate causes fluctuation in the value of investment. In the event that interest rates decrease, fixed income securities prices increase, and vice versa. Therefore, fluctuating interest rates are an important source of investment risk.

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