Interest Rate Risk
Interest rate risk is more difficult to manage than the risk arising from market variables such as equity prices, exchange rates, and commodity prices. One complication is that there are many different interest rates in any given currency (Treasury rates, interbank borrowing and lending rates, swap rates, mortgage rates, deposit rates, prime borrowing rates, and so on). Although these tend to move together, they are not perfectly correlated. Another complication is that we need more than a single number to describe the interest rate environment. We need a function describing the variation of the rate with maturity. This is known as the term structure of interest rates or the yield curve.
Consider, for example, the situation of a U.S. government bond trader. The trader’s portfolio is likely to consist of many bonds with different maturities. There is an exposure to movements in the one-year rate, the two-year rate, the three-year rate, and so on. The trader’s delta exposure is therefore more complicated than that of the gold trader in Table 7.1. He or she must be concerned with all the different ways in which the U.S. Treasury yield curve can change its shape through time.
This chapter starts with a description of traditional approaches used by a financial institution to manage interest rate risk. It explains the importance of LIBOR and swap rates to financial institutions. It then covers duration and convexity measures. These can be regarded as the ...