In additions to the long
run implications of the interest rate changes, there are short term
fluctuations which are to be considered in deciding on the mix of assets and
liabilities, the pricing policies and thereby the business volumes. However,
the risk will acquire serious proportions in a highly volatile market when the
impact will be felt on the cash flows and profits. The 1994 volatility
witnessed in the Indian call money market explains the presence and the impact
of volatility risk. The interest rate in the call money market, which generally
hovered around 5-7 %, zoomed to 95% within a couple of weeks during September,
1994. While some banks defaulted in the maintenance of CRR, many banks borrowed
funds at high rates, which had substantially reduced their profits. Thus, it
can be seen that the affect of fluctuations in the short term have a greater
impact since the adjustment period is very short.
Prepayment Risk
The fluctuations in the
interest rate may sometimes lead to prepayment of loans. For instance, in a
situation where the interest rate is declining, any cash inflows that arise due
to prepayment of loans will have to be redeployed at a lower rate invariably
resulting in lowered yields.
Call/Put Risk
Sometimes when the funds
are raised by the issue of bonds/securities, it may include call/put options. A
call option is exercised by an issuer to redeem the bonds before maturity,
while the put option is exercised by the investor to seek redemption before
maturity. These two options expose to a risk when the interest rate fluctuate.
A call option is generally exercised in a declining interest rate scenario.
This will affect the bank if it invests in such bonds since the intermediate
cash inflows will have to be reinvested at a lower rate. Similarly, when the
investor exercises the put option in an increasing interest rate scenario, the
banks, which issue the bonds, will have to face greater replacement costs.
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