Interest rate risk arises when there is a mismatch between positions, which are subject to interest rate adjustment within a specified period. The vulnerability of an towards the adverse movements of the interest rate can be gauged by using duration GAP analysis or similar other interest rate risk models, Interest rate risk may arise due to (i) differences between the timing of rate changes and the timing of cash flows (re-Pricing risk); (ii) changing rate relationships among different yield curves effecting bank’s activities (basis risk); (iii) changing rate relationships across the range of maturities (yield curve risk); and (iv) interest- related options embedded in bank products (options risk). Banks should conduct stress tests for interest rate risk keeping in view the nature and composition of their portfolios. Some plausible scenarios relating to interest rate risk may include the following:
i.
Re-pricing Risk: Banks may develop stress scenarios to assess the impact on their profitability of the timing differences in interest rate changes and cash flows in respect of fixed and floating rate positions on both assets and liabilities side including off-balance sheet exposures;
ii.
Basis Risk: This scenario would involve assessing the impact on profitability due to unfavorable differential changes in key market rates;
iii.
Yield Curve Risk: This scenario may assess the impact on profitability due to parallel shifts in the yield curve (both up and down shifts) and non-parallel shifts in the yield curve (steeping or flattening of the yield curve);
iv.
Option Risk: Banks may develop this scenario if they have significant exposure to option instruments. This would involve assessing the impact on profitability due to changes in the value of both stand-alone option instruments (e.g. bond options) and embedded options (e.g. bonds with call or put provisions and loans providing the right of prepayment to the borrowers) due to adverse interest rate movements.
