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Interest Rate Risk Management and Financial Derivatives Essay


Global markets have been characterized by fluctuations that have affected economies to a considerable extent. The banking sector is one of the industries that have been subjected to significant environmental changes, including the diversification of products and services, a situation that currently requires players to prioritize the management of interest rate risk (IRR). The IRR issue is a noteworthy problem that the global banking system has faced since the great recession. Managers of small banks have regarded IRR as a major problem that is currently undermining their profitability compared to what is being witnessed in large financial organizations. In this respect, it is crucial to consider the establishment of measures that facilitate the assessment and management of IRR to facilitate the sustainability of both small and big players in the industry. In this concern, this paper reviews the available literature concerning the sources of interest rate risks, the underlying impacts on financial institutions, and the approaches adopted by financial institutions to facilitate the measurement and management of IRR.

Sources of IRR

The study by Beets (2004) regards IRR as an issue that affects the financial position of players in the banking sector to a considerable extent. In this concern, it is relevant for players in the banking sector to assess factors that account for interest rate fluctuations since they subject the capital base and industry players’ earnings to significant pressure. In this concern, the Federal Housing Finance Agency (2013) reveals “repricing risk, base risk, yield/output curve risk, and optionality risk” (p. 1) as the major root behind the prevalence of IRR in the banking industry. In line with the views of Sharifi, Saeidi, and Saeidi (2014), the repricing threat is a significant trigger of IRR in many financial organizations. According to Basel Committee on Banking Supervision (2004), timing disparities linked to maturity, as well as the repricing of banks’ material goods, expenses, and off-balance-sheet (OBS) positions contribute to the development of IRR.

Important to note, repricing irregularities are among the fundamental aspects of operations that financial institutions undertake. As a result, as the Basel Committee on Banking Supervision (2004) uncovers, such mismatches may expose financial industry stakeholders to poor returns in addition to lowering their economic significance, more so in the event interest rates swing drastically. As a result, financial institutions that deploy temporary deposits to sponsor a long-standing flat rate credit may witness minimal profits and/or a lower net worth in case the interest rates scale up. Thus, as the Basel Committee on Banking Supervision (2004) unearths, repricing disparities subject financial agencies to significant monetary consequences that may undermine the sustainability of players in the industry.

The study by Beets (2004) presents basis risk as a significant source of IRR in the banking industry. Specifically, basis risk emerges from the faulty regulation of the charges realized and/or compensated on an array of tools that have similar repricing characteristics. In this respect, interest rate inconsistencies may lead to the development of unforeseen changes in currency movement, as well as income spread associated with OBS tools, resources, and expenditures. Important to note, these tools possess comparable recurrence levels. The application of various strategies for identifying the interest rate realized in each wing of the balance sheet has the potential of subjecting banking agencies to basis risk to the extent of undermining the returns realized from the final interest. Hence, the basis risk is among the considerable sources of IRR experienced by banking organizations today.

According to the Basel Committee on Banking Supervision (2004), the optionality issue surrounding different investments in the banking industry also influences the development of IRR. Here, the proprietor enjoys the autonomy of determining the procurement, trading, or the changing of a particular investment plan. In the banking sector, options may take the arrangement of individual instruments such as over-the-counter tools or exchange-traded alternatives. It is also possible to integrate options into the available typical instruments. Therefore, investors have the freedom to determine the transactions they make using instruments such as bonds and notes. As a result, the liberty or optionality aspect allows depositors to access funds at their convenient time, a situation that exposes financial organizations to low-interest earnings. In this regard, managers in the banking sector need to consider the optional aspect during the appraisal and management of IRR.

Alterations in repricing may also influence the nature, as well as the inclination of the output curve of financial institutions. As a result, Guibaud, Nosbusch, and Vayanos (2013) reveal how the output curve risk may prompt the emergence of IRR in a way that negatively affects the financial health of financial agencies. In this concern, changes in the degree of market productivity have a substantial influence on the price of a specific fixed-revenue investment tool. In this regard, an increase in market yields may result in a corresponding decrease in the price of a bond in which a financial institution has invested some resources. The situation can lower the earnings of the banking agency, a situation that indicates the negative implication of market productivity variations on the financial health of financial institutions. Furthermore, unforeseen discrepancies in the productivity curve have the potential of destabilizing banks’ returns, as well as their monetary significance. Also, savings linked to predetermined instruments may subject banking agencies to extreme interest rates, which may weaken their revenue volumes. Thus, as Guibaud et al. (2013) indicate, the output curve risk is a considerable factor that may prompt IRR in a given financial system because it determines the value of fixed-revenue investment tools.

The Impact of IRR on Banking Organisations

As noted in the previous section, the IRR problem subjects banking agencies to financial issues that destabilize the sustainability of their operations in the industry. In particular, the fluctuation of interest rates has negative effects on the revenue and ultimate worth of financial organizations in various economies globally. In this respect, examining the extent to which unprecedented interest rate variations influence the financial health of players in the banking industry is indispensable. The IRR problem influences the net interest revenue that banking agencies realize from their operations in the market. According to Ozdemir and Sudarsana (2016), IRR has the potential of causing significant differences between the aggregate interest cost and the net proceeds. Notably, a considerable majority of players in the banking sector attain their revenue from the interest rate proceeds. Therefore, it is important to safeguard the income realized from interest rates by accurately measuring and managing IRR.

Interest rate variations in the banking system pose significant implications on the collective income of industry players. According to Ozdemir and Sudarsana (2016), risk managers in the banking system handle the issue of IRR by examining the extent to which it influences the earnings attained over a given financial calendar. Extreme interest rate fluctuations account for the recorded minimal earnings or even cumulative losses incurred by financial sector players (Ozdemir & Sudarsana, 2016). Furthermore, the risk management team acknowledges the IRR issue as an aspect that not only leads to capital shortage but also weakens the existing market stability. Therefore, it is evident that extreme interest rate changes contribute to the dismal financial performance of banking organizations.

As Frey (2015) asserts, unexpected extreme interest rate variations also adversely affect the income realized from non-interest operations of financial institutions. For this reason, banks report lower earnings from deal-dispensation charges in the event far-reaching interest rates rock the market. This finding confirms that the IRR issue is indeed a major contributor to the deteriorated revenue from interest, as well as non-interest income endeavors. As such, the radical interest rate changes may lead to the meager performance of financial institutions.

Drastic movements in market interest rates have the potential of triggering considerable currency flow in the banking system, thus resulting in an unpredictable economic standing of players in the sector. According to Ogbeide and Akanji (2017), the impact of currency movements on the financial position of a competitor in the banking sector poses significant effects on its economic rating. It is possible to estimate the value of a particular financial body by getting the difference between the likely cash flow linked to the prevailing expenses and any possible currency volatility level associated with resources and summing up the outcome with the anticipated currency distribution as revealed in a bank’s OBS components. In this concern, key stakeholders in the sector, including shareholders, directors, as well as administrators, need to consider the employment of risk management strategies that safeguard a particular bank from recording deteriorated economic worth. They can achieve this goal by paying attention to their cash flows.

Interest rate risk also affects various platforms that determine the net worth of banking organizations. Consequently, as Beets (2004) reveals, unstable interest rate variations have the potential of shaping the economic significance of a monetary agency’s off-balance-sheet tools, material goods, and liabilities. For this reason, shareholders, administrators, and directors view the state of interest rate instability in the market as a determinant of the ultimate worth of monetary agencies. According to Beets (2004), a bank’s usual currency circulation levels play a crucial part in determining its economic standing in the industry. Such levels indicate the value of the agency’s material goods that get in or out of the organization. Important to note, bearing in mind that a financial organization’s cash circulation rate is a function of its OBS positions, liabilities, and material goods, IRR may influence its monetary position since interest rate fluctuations determine the choice of instruments to deploy. In this respect, the impact of IRR on the currency flow of various banking agencies has corresponding direct consequences on the economic value of such institutions.

How Financial Institutions Measure or Manage IRR

The quantification and management of IRR is a crucial aspect of running financial institutions. For this reason, risk managers in the sector acknowledge the essence of measuring and managing the forces of IRR to ensure that banks realize desirable financial outcomes amid the instability of interest rates in the market. Notably, various approaches facilitate the measurement and management of IRR in the financial sector. According to Beets (2004), banking agencies facilitate the management of IRR by either applying the traditional GAP analysis or the modern financial derivatives approach. However, the overall goal is to control the threat posed by interest rate fluctuations. In this respect, it is crucial to identify how the mentioned methods of measuring and managing IRR work.

How GAP Analysis and Financial Derivatives Function

GAP analysis concentrates on estimating risks, which constantly influence the interest returns that a banking company realizes over a specified period. According to the Basel Committee on Banking Supervision (2004), GAP analysis helps in identifying variations between the cost of liabilities and property as revealed by changes in interest rates over a given period. As such, the GAP analysis incorporates an asset-liability strategy for assessing and managing IRR in the financial sector (Basel Committee on Banking Supervision, 2004). The straightforwardness of this risk management approach uncovers the degree to which variations in interest rates influence the value of assets and liabilities in a particular financial institution.

On the other hand, the financial derivative approach of quantifying and managing IRR is a modern way of addressing the IRR issue in the field of banking. According to Beets (2004), financial derivatives emanate from a single or multiple financial assets that facilitate the valuation of instruments. The wide range of financial derivatives in the banking system includes financial security, securities index, or a combination of both securities, as well as indices (Hull & Basu, 2016). Indices also incorporate financial commodities that may be traded in the banking sector. The notable financial derivatives in the banking industry include futures, options, swaps, and forwards. Therefore, as Beets (2004) reveals, estimating returns from such financial derivatives helps financial institutions to determine the extent to which the fluctuation of interest rates may undermine their performance.

Merits and Demerits of GAP and Financial Derivatives

As the Basel Committee on Banking Supervision (2004) reveals, the traditional GAP analysis is a useful tool for managing the risk associated with interest risk fluctuations. Notably, the instrument offers managers the advantage of facilitating the comparison of a bank’s prevailing performance regarding net interest earnings with the anticipated productivity levels. Another advantage associated with the traditional GAP analysis is that the tool helps in assessing the performance of a banking agency within a specified period. In this respect, according to the Basel Committee on Banking Supervision (2004), a property-receptive “gap” portrays that a financial institution’s possessions exceed its liabilities. This information reveals a positive performance of the bank’s net interest earnings. Conversely, the realization of a liability-receptive “gap” infers that a financial agency may attain reduced net interest earnings. Therefore, the GAP analysis is instrumental in determining the extent to which IRR affects a banking organization’s net income earnings.

Nonetheless, the GAP analysis fails to consider the changes in spreads regarding interest rates, which may be linked to market oscillations. Furthermore, according to Beets (2004), the GAP analysis technique disregards the optionality element of assets and liabilities as an important factor that triggers IRR. Also, the traditional GAP analysis technique is unreliable since non-maturity deposits may affect the proportionality of repricing actions undertaken by a financial institution.

Regarding financial derivatives, Beets (2004) present the “forwards” aspect as advantageous since it entails a legally binding agreement, which enhances the buying and selling of government securities, commodities, or international currency among other financial tools at a particular price and time of delivery and/or settlement. According to Curcio, Anderson, and Guirguis (2017), despite being similar to “forwards”, the “futures” element offers the advantage of intermediaries that lessen the risk involved in transactions. Other financial derivative components such as interest rate swaps facilitate the collection of prospective cash flows, thus determining the predictability of a bank’s performance (Beets, 2004). Options also offer managers the benefit of facilitating the administration of interest rates. Specifically, options avail the required underlying security in the arrangement of a debt obligation. However, financial derivatives have the drawback of demanding financial agencies to part with a specified amount of revenue if they wish to access various instructions to facilitate the assessment and administration of interest rate risks.


The expositions made in the paper suggest that the IRR problem is indeed a significant issue in the contemporary banking sector. Shockingly, the current IRR levels have almost reached the pre-recession numbers to the extent of calling for the integration of necessary measures that can foster the sustainability of the banking sector. The underlying factors or sources that trigger the issue include repricing, basis, productivity curve, and optionality threats among other aspects. The adversity of IRR undermines the financial performance of businesses in the banking sector by weakening their revenue and net worth. For this reason, risk managers in the sector deploy instruments such as the GAP analysis and financial derivatives to measure and manage IRR.


Basel Committee on Banking Supervision. (2004).Web.

Beets, S. (2004). The use of derivatives to manage interest rate risk in commercial banks. Investment Management and Financial Innovations, 2, 60-74.

Curcio, R., Anderson, R., & Guirguis, H. (2017). On the use of US treasury futures and futures options to hedge risk in portfolios of mortgage REITs. Real Estate Finance, 33(4), 155-167.

Federal Housing Finance Agency. (2013). Web.

Frey, A. (2015). Facing the interest rate challenge: A key risk management issue for insurers. Journal of Risk Management in Financial Institutions, 8(2), 147-152.

Guibaud, S., Nosbusch, Y., & Vayanos, D. (2013). Bond market clienteles, the yield curve, and the optimal maturity structure of government debt. The Review of Financial Studies, 26(8), 1913-1961.

Hull, J. C., & Basu, S. (2016). Options, futures, and other derivatives. New York, NY: Pearson Education.

Ogbeide, S., & Akanji, B. (2017). A Study on the relationship between cash-flow and financial performance of insurance companies: Evidence from a developing economy. Review of International Comparative Management, 18(2), 148-157.

Ozdemir, B., & Sudarsana, G. (2016). Managing interest rate risk in the banking book using an optimization framework. Journal of Risk Management in Financial Institutions, 9(4), 373-390.

Sharifi, O., Saeidi, M., & Saeidi, H. (2014). Interest rate risk management using income and duration gap analysis in banks – An empirical study. Management Research Report, 2(7), 3058-3071.

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