Interest rate risk is the potential for investment losses that can be prompted by a move upward in the prevailing rates for new debt instruments.
Interest rate changes can affect many investments, but it impacts the value of bonds and other fixed-income securities most directly. As interest rates rise bond prices fall, and vice versa. When interest rates rise to a point above that fixed level, investors switch to investments that reflect the higher interest rate.
If interest rates rise, for instance, the value of a bond or other fixed-income investment in the secondary market will decline. Conversely, bond prices increase after a drop in interest rates. So, Securities that were issued before the interest rate rise can compete with new issues only by dropping their prices.
Interest rate risk is measured by a fixed-income security’s duration, with longer-term bonds having greater price sensitivity to rate changes. The sensitivity depends on two things, the bond’s time to maturity, and the coupon rate of the bond. Thus, Interest rate risk can be managed through hedging or diversification strategies that reduce a portfolio’s effective duration or negate the effect of rate changes.
Impact of interest risk on banking book:
Interest Rate Risk in Banking Book (IRRBB) refers to the current or prospective risk to banks’ capital and earnings arising from adverse movements in interest rates that affect their banking book positions. Excessive IRRBB can pose a significant risk to banks’ current capital base and/or future earnings. Therefore, banks are required to measure, and monitor, through the ‘Asset Liability Management (ALM) system’ which requires banks to undertake Traditional Gap Analysis and disclose their exposure to IRRBB in terms of the latest RBI circular dated 17.02.2023.