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Interest rate risk



Category: Corporate Governance

Interest rate risk. The risk arising from movements in interest rates. Interest rate risk arises from differences between the timing of rate changes and the timing of cash flows (repricing risk); from changing rate relationships among different yield curves affecting bank activities (basis risk); from changing rate relationships across the spectrum of maturities (yield curve risk); and from interest-related options embedded in bank products (options risk). Very often the interest risk is linked to the political risk.

Bank Supervisory Council and Management Board members must monitor the asset/liability management function closely, generally through the work of the asset/liability committee (ALCO). The cost of funds is managed here, as is the matching of term of deposits to term of money lent and the margin of profit, or spread, created.

In September 1997, Basel Committee has also released guidelines specifically for interest rate risk management -«Principles for Management of Interest Rate Risk». It contains 11 principles and they are grouped into 4 sections: role of Supervisory Council and senior management in risk management; Policies and procedures; Measurement and monitoring system, Internal controls; Information for supervisory authority.

NBU in its risk assessment will be analyzing the following components of interest rate risk: interest rate repricing risk, interest rate mismatch, adequacy of policies and procedures, methods of monitoring and reporting of interest rate risk.

Example:

The most famous example of losses sustained from the interest rates fluctuations was the Long Term Capital Management Fund (LTCM) in the USA.

John Meriwether, who founded Long-Term Capital Partners in 1993, had been head of fixed income trading at Salomon Brothers. Teamed up with a handful of these traders, two Nobel laureates, Robert Merton and Myron Scholes, and former regulator David Mullins, Meriwether and LTCM had more credibility than the average broker/dealer on Wall Street.

It was a game, in that LTCM was unregulated, free to operate in any market, without capital charges and only light reporting requirements to the US Securities & Exchange Commission (SEC). It traded on its good name with many respectable counterparties as if it was a member of the same club. This meant an ability to put on interest rate swaps at the market rate for no initial margin — an essential part of its strategy. It meant being able to borrow 100% of the value of any top-grade collateral, and with that cash to buy more securities and post them as collateral for further borrowing: in theory it could leverage itself to infinity. In LTCM’s first two full years of operation it produced 43% and 41% return on equity and had amassed an investment capital of $7 billion.

Trades typical of early LTCM were, for example, to buy Italian government bonds and sell German Bund futures; to buy theoretically underpriced long term US treasury bonds (because they are less liquid) and sell short term (more liquid) treasuries. It played the same arbitrage in the interest-rate swap market, betting that the spread between swap rates and the most liquid treasury bonds would narrow.

Then it ventured into equity trades. It took speculative positions in takeover stocks. A filing with the SEC for June 30 1998 showed that LTCM had equity stakes in 77 companies, worth $541 million. It also got into emerging markets, including Russia. One report said Russia was «8% of its book» which would come to $10 billion!

The big trouble for LTCM started on July 17 when Salomon Smith Barney announced it was liquidating its dollar interest arbitrage positions. For the rest of that month, the fund dropped about 10% because Salomon Brothers was selling all the debt and equity securities that LTCM owned.

On August 17,1998 Russia declared a moratorium on its rouble debt and domestic dollar debt. Hot money, already jittery because of the Asian crisis, fled into high quality instruments. Top preference was for the most liquid US and G-10 government bonds. Spreads widened even between short term and long term US treasuries.

Most of LTCM’s bets had been variations on the same theme, convergence between liquid treasuries and more complex instruments that commanded a credit or liquidity premium. Unfortunately convergence turned into dramatic divergence.

On September 2, 1998 Meriwether sent a letter to his investors saying that the fund had lost $2.5 billion or 52% of its value that year, $2.1 billion in August alone. Its capital base had shrunk to $2.3 billion


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