INTEREST RATE RISK
As we all know interest rates fluctuate and it can be difficult to predict future movements, which is why the risk has to be managed. The level of interest rates in any domestic market is determined by many factors but the main ones are:
- Supply and Demand
- Government monetary policy
- Current economic climate
- Currency Strength
The management of interest rate risk in the short term cash money market is dependent upon whether you are a borrower, or a lender of funds. A borrower of funds’ risk is that if the interest rates come down, you could have waited and borrowed at a lower rate. The following example shows this principle: –
A dealer borrows money at 5%, for a three-month period, then the following day interest rates for the three-month period move down to 4.75%. If the dealer had waited one more day, he could have borrowed at this lower rate, i.e. paid less interest.
A borrower then of course would always want to borrow funds as cheaply as possible. A lender of funds’ risk is that if interest rates go up, you could have waited and lent at a higher rate, see example:
A dealer lends money at 5% on a three-month basis, the next day the interest rate goes up to 5.25%, if the dealer had waited one more day he could have lent at this higher rate, and received more interest on the loan. Therefore, a lender will want to lend funds as expensively as possible.
A bank will account for all such transactions mentioned above, on what is known as its Balance Sheet, which is split into assets and liabilities. Operations such as cash loans (assets) and deposits (liabilities) that actually involve physical payment and consequent risk are therefore termed ‘On Balance Sheet exposures’. Having ‘On Balance Sheet’ exposures dictates that a bank is required by regulatory bodies, and Capital Adequacy Directive (CAD) to set aside, for no return, a proportion of its capital, in case of non-repayment and doubtful debts. This is an important aspect of all money market trading, as it can make ‘On Balance Sheet’ trading expensive to conduct.