This document discusses the different types of interest rate risk that financial institutions face: repricing risk, which is the risk from timing differences in rate changes of assets and liabilities; yield curve risk, which is the risk of non-parallel shifts in the yield curve; option risk, which includes the risk of changes in cash flows due to embedded options like prepayments; and basis risk, which is the risk that different indices do not move together. It provides examples and definitions for each type of interest rate risk. Effective management of these various risks is important for financial institutions.

1. Interest Rate Risk
II. Types of Interest Rate Risk

2. FEDERAL DEPOSIT INSURANCE CORPORATION
Types of Interest Rate Risk
INTEREST
RATE RISK
Yield
Curve Risk
Option
Risk
Basis Risk
Repricing
Risk

3. FEDERAL DEPOSIT INSURANCE CORPORATION
The risk from timing differences
between rate changes or cash flows
from assets, liabilities, and off-balance
sheet instruments
Definition of Repricing Risk
=
Repricing
Risk

4. FEDERAL DEPOSIT INSURANCE CORPORATION
Assume a 2% increase in time deposit rates in the second year
Example of Repricing Risk
15‐Year Mortgage
1‐Year Time Deposit
Net Interest Spread
Period 1
4.00
1.00
3.00
Period 2
4.00
3.00
1.00

5. FEDERAL DEPOSIT INSURANCE CORPORATION
The risk from non-parallel changes
in the yield curve
Definition of Yield Curve Risk
=
Yield
Curve Risk

6. FEDERAL DEPOSIT INSURANCE CORPORATION
0
1
2
3
4
5
6
3M 1Y 5Y 10Y 30Y
Yield Curve – 2004 to 2006
Rate, %
1Q 2006
1Q 2005
1Q 2004
Source: Federal Reserve Board/Haver Analytics
 Strategy: Borrow short and lend
long
 Risk: Yield curve flattens
 1Q 2004: Short-term interest
rates began to rise sharply
 2006 or 2007: Flat or inverted
yield curve
Yield Curve Shifts: A Recent Example of
Flattening

7. FEDERAL DEPOSIT INSURANCE CORPORATION
15‐Year Mortgage
1‐Year Time Deposit
Net Interest Spread
Period 1
6.00
1.00
5.00
Period 2
6.50
4.00
2.50
Example of Yield Curve Risk
Flattening Yield Curve: short-term rates rise faster than
long-term rates and reduce net interest income

8. FEDERAL DEPOSIT INSURANCE CORPORATION
the risk that cash flows change due
to embedded options
(e.g., prepayment / extension, call
options, deposit runoff)
Definition of Option Risk
=
Option
Risk

9. FEDERAL DEPOSIT INSURANCE CORPORATION
Option Risk
• Residential mortgages
• Mortgage-backed securities
• Callable bonds
Assets
• Non-maturity deposits
• Time deposit redemptions
• Certain FHLB borrowings
Liabilities

10. FEDERAL DEPOSIT INSURANCE CORPORATION
15‐Year Mortgage
3‐Year Time Deposit
Net Interest Spread
Period 1
7.00
4.00
3.00
Period 2
5.00
4.00
1.00
Assume a 2% Decrease in Mortgage Interest Rates.
Customer refinances in Period 2.
Example of Option Risk

11. FEDERAL DEPOSIT INSURANCE CORPORATION
0
250
500
750
1,000
0 30 60 90 120 150 180 210 240 270 300 330 360
Months
Increase in Average Life of Mortgage Pool
11 years
6.5 years
4.5 years
$, In Thous.
Rate scenarios
+100 bps
Stable +300 bps
Example of Option Risk

12. FEDERAL DEPOSIT INSURANCE CORPORATION
Mortgage Backed Securities are More Price
Sensitive as Rates Rise
$50
$75
$100
$125
$150
3 4 5 6 7 8 9 10
Price Change for MBS vs. Treasury
Treasury‐10yr (positive convexity)
MBS (negative convexity)
Hypothetical Rate
Negative Convexity: As interest rates rise, MBS portfolios stand to lose
more value than non-callable bonds
Yield (%)
Price ($)

13. FEDERAL DEPOSIT INSURANCE CORPORATION
The risk that different indices with the
same repricing frequency do not move
in unison
Definition of Basis Risk
=
Basis Risk

14. FEDERAL DEPOSIT INSURANCE CORPORATION
Short-term rates increase unevenly: 3-month Treasury
increases 1% and LIBOR increases 2%
Example of Basis Risk
3‐Month Treasury‐based Loan
3‐Month LIBOR‐based Borrowing
Net Interest Spread
Period 1
3.25
1.00
2.25
Period 2
4.25
3.00
1.25

15. FEDERAL DEPOSIT INSURANCE CORPORATION
Summary
 Interest Rate Risk has several components including:
• Repricing Risk
• Yield Curve Risk
• Option Risk
o Prepayment / Extension Risk
• Basis Risk
 How financial institutions identify, measure, monitor,
and control these risks is critical to an effective IRR
Management program