Basis Risk
When the cost of
liabilities and the yields of assets are linked to different benchmarks resulting
in a floating rate and there is no simultaneous matching movement in the
benchmark rates, it leads to basis risk. For instance, consider that the funds
raised by way of 1 yr bank deposits are invested in the Easy Exit Bond of the
IDBI flexi bond issue. In this case, the cost of funds for 1 yr bank deposits
will be 9%( 1 % less than the prevailing Bank Rate 10%), while the yields from
the bonds will be14.55% which is 1.5% over 10 yr government bond of 13.05%. With
these floating rates of interest, on the assets and liability spreads of 5.55%
(14.55-9) is available. Assume that there is a 1% cut in the bank rate. This
will bring down the cost of funds to 8%. Further, assume that the return on 10
yr government bond has also come down to 12.75%, thereby bringing down the
return on the Easy Exit Bond to 14.25%. As a result of this interest rate
change, the spread will increase to 6.25%. While the bank rate declined by 1%,
the yield on 10 yr government security came down only by 30bp.
Thus, when the change in
the interest rates, which are set as a benchmark for assets/liabilities, is not
uniform, it will lead to a decrease/increase in the spreads.
Real Interest Rate Risk
Yet another dimension of
the interest rate risk is the inflation factor, which has to be considered in
order to assess the real interest cost/yields. This occurs because the changes
in the nominal interest rates may not match with the changes in inflation.
The presence of the above mentioned
risk would either individually or collectively result in interest rate risk.
These risks will affect the income/expenses of the bank’s asset/liability
portfolio. This, further, will also have an impact on the value of assets and
liabilities of the bank, thereby affecting even the market value of the bank.
Some of the approaches
used to tackle interest rate risk are given below and a discussion on the same
is followed.
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