Managing Interest Rate Risk: The Next Challenge?

29 Pages Posted: 26 Apr 2009 Last revised: 11 Nov 2019

See all articles by Sanjay K. Nawalkha

Sanjay K. Nawalkha

University of Massachusetts Amherst - Isenberg School of Management

Gloria M. Soto

University of Murcia - Faculty of Business and Economics

Date Written: August 17, 2012

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

Suggested Citation

Nawalkha, Sanjay K. and Soto, Gloria M., Managing Interest Rate Risk: The Next Challenge? (August 17, 2012). Available at SSRN: https://ssrn.com/abstract=1392543 or http://dx.doi.org/10.2139/ssrn.1392543

Sanjay K. Nawalkha (Contact Author)

University of Massachusetts Amherst - Isenberg School of Management ( email )

Amherst, MA 01003-4910
United States
413-687-2561 (Phone)

Gloria M. Soto

University of Murcia - Faculty of Business and Economics ( email )

Spain

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
1,409
Abstract Views
5,356
rank
13,657
PlumX Metrics