[sbinews] What is interest rate risk? (Business Line)

  • From: rajendra.pai@xxxxxxxxx
  • To: sbinews@xxxxxxxxxxxxx
  • Date: Thu, 04 Dec 2003 06:58:28 +0500 (IST)

What is interest rate risk? 
(Business Line) 
B. Venkatesh 

IN THE latest Report on Trends and Progress of Banking in India, the Reserve 
Bank of India has cautioned commercial banks of interest rate risk. What is 
this risk? 

Suppose the market demands a 5.5 per cent yield on a 10-year bond. If the 
coupon rate is also 5.5 per cent, the bond will trade at par, which is Rs 100. 

But what if the market demands a yield of 6 per cent on a 10-year bond? There 
will be no demand for the 5.5 per cent 10-year bond. 

So, the price of the 5.5 per cent coupon 10-year bond will decline in value 
such that it yields 6 per cent. Those who hold bonds, therefore, run the risk 
of interest rate increase. This risk is called the interest rate risk. 

Note the inverse price-yield relationship. Bond prices rise when interest rate 
decline, and prices fall when interest rate increases. 

Now, interest rate risk is dependent on the maturity of the bond; longer the 
bond maturity, higher the interest rate risk. So, the 5.5 per cent 10-year bond 
will decline more to yield 6 per cent compared with a 5.5 per cent five-year 
bond. Why? 

When you buy a bond, you receive interest every year and the redemption price 
on maturity. The bond price is, hence, a function of the present value of these 
cash flows. When the market demands higher yield, we have to use a higher 
discount factor to calculate the present value of cash flows. 

In the case of a 10-year bond, we have to use the higher discount factor for 10 

For a five-year bond, a higher discount factor has to be used only for five 
years. But higher discount factor means lower price. That is why longer 
maturity bonds are more sensitive to increase in interest rates.

Email From "rajendra.pai@xxxxxxxxx" was security checked by 3.90  version of 
On: mail_store at: 06:58:28, 04-Dec-2003 Thursday
Mailing list (sbinews@xxxxxxxxxxxxx) related information:

News/articles about SBI and Banking related matters published  in the print 
media, Internet etc will be circulated through this Mailing List. 

The messages in this list will help in improving awareness of SBI and its 
activities vis-a-vis the happenings in the Banking industry. This should be of 
help to all staff members of SBI, particularly those who are preparing for 
promotional written tests/interviews/group discussions. Subscription to this 
Mailing List is simple and FREE. Please check the procedure below. Please share 
this information with other colleagues/branches that could be interested in 
subscribing to this Mailing List. 

The messages circulated here should not be deemed to have the official 
endorsement of the SBI or any of its employees. The correct factual position 
may be ascertained from official sources. 

To join this mailing list, just send an email to sbinews-request@xxxxxxxxxxxxx 
with the word 'subscribe' without the quotes in the subject of the email 

To leave this mailing list, just send an email to sbinews-request@xxxxxxxxxxxxx 
with the word  'unsubscribe' without the quotes in the subject of the email 

Archives (old messages) are available for viewing at:
Click on the month-year at the lower left corner to view messages posted during 
that month. 

This is an announcements/newsletter type mailing list i.e. only the Moderator 
can post messages to the list. 

This mailing list is maintained by Sri. R.S.Pai, currently working as Chief 
Manager(IT-Internet Banking), SBI, Corporate Centre, Mumbai. 
Visit http://rspai.tripod.com for some useful Banking, Reference and Utilities 

Other related posts:

  • » [sbinews] What is interest rate risk? (Business Line)