Interest rate risk is the chance that the value of interest-bearing assets or liabilities will change in price based on fluctuations in interest rates. The value of interest-bearing assets is inversely related to interest rates. For example, when interest rates increase, bonds generally fall in value. Conversely, when interest rates fall, bonds generally rise in value. As a result, banks and firms that own significant interest-bearing assets and liabilities are particularly focused on managing interest rate risk.
Often the most significant source of interest rate risk is the repricing risk. Repricing risk relates to the fact that different assets and liabilities may be priced at different times and rates. For example, a bank may lend money at fixed rates and pay interest on deposits at variable rates. Changes to the variable interest rate expose the bank to repricing risk.
Certain assets and liabilities contain owner options that may alter the standard terms and durations of the assets and liabilities. For example, many mortgages allow mortgage holders to prepay. If interest rates fall, mortgage holders with fixed rated mortgages may elect this option. Additionally, some loans may allow holders to extend their loans at defined terms. If interest rates rise, loan holders may elect to extend their loans.
Maturity risk occurs when the maturities of the assets and the liabilities held by a company are mismatched. Banks, which typically borrow in the short term and lend long term, will typically have a maturity gap. A maturity gap opens the firm to yield curve risk.
Yield Curve Risk
Yield curve risk is the risk that the yield curve will fluctuate. The yield curve is the relationship between the interest rates of short-term and long-term loans. Typically, short-term interest rates are lower than long-term interest rates. However, the relationship between these rates often fluctuates, which exposes a firm with a maturity gap to interest rate risk.