Managing Interest Rate Risk: The Next Challenge?

Abstract:     
Are the managers of financial institutions ready for the small but increasingly significant risk of inflation in the near future, due to the unprecedented fiscal and monetary responses of the U.S. government to prevent an economic collapse? This paper addresses this important issue by reviewing important findings in the area of interest rate risk management. We discuss five classes of models in the fixed income literature that deal with hedging the risk of large, non-parallel yield curve shifts. These models are given as M-Absolute/M-Square models, duration vector models, key rate duration models, principal component duration models, and extensions of these models for fixed income derivatives, for valuing and hedging bonds, loans, demand deposits, and other fixed income instruments. These models can be used for designing various hedging strategies such as portfolio immunization, bond index replication, duration gap management, and contingent immunization, to protect against changes in the height, slope, and curvature of the yield curve. We argue that the current regulatory models proposed by the U.S. Federal Reserve, the Office of Thrift Supervision, and the Bank of International Settlements, may understate the true interest rate risk exposure of financial institutions, if sharp increases in interest rates lead to higher default risk and quickening of the pace of deposit withdrawals.

Keywords: interest rate risk, duration, convexity, key rate, inflation

JEL Classifications: G10, G11, G12, G13, G20, G21, G22, G23, G24, G28

Working Paper Series