Understanding and Managing Interest Rate Risk

By Chris Pentago posted 03-08-2018 06:20 AM

  

While the Reserve Bank of Australia has ruled out a hike on interest rates, at least until wages increase, there have long been talks of interest rates rising, which is why it’s important for borrowers to be prepared. As an investor, you need to understand interest rate risk, how to measure it, as well as how to manage it. Whether you develop your own interest rate risk management strategies, or you seek the help of a Risk Management Specialist to find a suitable financial product to help manage the risks, there are several options borrowers can take to deal with the risks involved with interest rates. 

Understanding Interest Rate Risk

While you may understand the basics of interest rates, such as what is it, the difference between variable and fixed rates, and partially-fixed interest, interest rate risk may not be something you are very familiar with. However, it’s important that you understand interest rate risk and how to manage it, as any fluctuations in interest rate can impact on an organisation’s profitability or negatively affect borrowers due to an increase in borrowing costs.

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Managing the Risk

Interest changes can have a significant impact on borrowers, so you will need to determine which interest rate risk management strategies will best suit your business. You may find that choosing either variable or fixed interest rates is not enough. The reason being that variable interest rates leave you exposed to the risk of interest rate hikes, whereas fixed rates do not allow you to benefit from falls in interest rates. A customised strategy will allow you to respond to any changes in interest rates accordingly.

The first step is to identify risks faced by the borrower. You will need to establish all assets and liability positions that are vulnerable to fluctuations in interest rates.
Different methods can be used to measure interest rate risk, including: 

  • Gap analysis
  • Scenario analysis
  • Duration analysis
  • Value at Risk (VaR)

You will then need to measure and quantify the risk of loss of your business’ earnings or asset value. Your findings will be used to formulate a risk policy framework that fits in with your risk/return profile. The aim is to manage interest rate risks at an appropriate cost for your company. Managing risks will allow you to gain a substantial amount of certainty while reducing borrowing costs and benefiting from improved interest rates, but you will need to take into account the cost involved in identifying and monitoring risks, as well as any costs and premiums associated with hedging the risk.

Risk Management Products

If you need help minimising interest rate risk or are looking for a way to obtain interest rate protection while still benefiting from lower interest rates, then you can look into interest rate risk management products that are specifically designed for the current interest rate environment. You will find that larger institutions offer specialist services that will help borrowers to find financial products designed to reduce uncertainties and interest rate risks, so you can enjoy the maximum benefits without worrying about the risks

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