This document discusses interest rate risk and how it can affect businesses. It is divided into income risk and capital risk. Income risk refers to the risk of changes in cash flows from fixed and floating interest rates. Capital risk is the reduction in the value of long-term financial assets due to changes in interest rates. The document also discusses asset-liability structure risk for banks, financial swaps, and the different types of swaps including currency swaps, cross-currency interest rate swaps, and interest rate swaps.

2. • INTEREST RATE RISK REFERS TO THE CHANGES IN THE CASHFLOWS
WHEN THERE IS CHANGES IN THE INTEREST RATES IN THE MARKET.
• DIVIVED INTO – INCOME RISK AND CAPITAL RISK.
 INCOME RISK
• 2 TYPES OF INTEREST RATES- FIXED AND FLOATING INTERESTS
RATES.
• FIXED INTEREST RATE REMAINS THE SAME THROUGH OUT THE
DURATION OF THE CONTRACT. EG: GOVERNMENT BOND FOR 5 YEARS.
• FIXED RATE- THE RISK IS MEASURED WITH RESPECT TO OPPORTUNITY
COST.
• FLOATING INTEREST RATE IS FIXED WITH REFERENCE TO A
BENCHMARK RATE [ i.e. LIBOR, MIBOR] AND CHANGES PERIODICALLY
WITH THE CHANGES IN THE BENCHMARK RATE.
• THE EFFECT OF FLOATING RATE IS TO KEEP THE INTEREST RATE IN
TUNE WITH THE CURRENT TRENDS.

3.  CAPITAL RISK
• APPLICABLE FOR BONDS ONLY.
• REDUCTION IN THE VALUE THAT A LONG TERM FINANCIAL ASSET
MAY SUFFER DUE TO CHANGE IN THE INTEREST RATE.
• EG: A GOVERNMENT BOND MATURING AFTER 5 YEARS @ 12%, IF THE
GOVERNMANT ISSUES A NEW BOND AT 14%, THE MARKET VALUE OF
12% GOVERNMENT BOND WILL FALL.
• CAPITAL RISK ARISES WHEN THE LONG TERM ASSETS ARE HELD FOR
A SHORT TIME,
• i.e. THE BANKS BUY THE GOVERNMANT SECURITIES WHEN THEY
HAVE SURPLUS FUNDS OR TO FULFILL THE LIQUIDUTY
REQUIREMENTS.THE SECURITIES ARE DISPOSED WHEN THE NEED
ARISES. HENCE THE BANKS HAVE GREATER CAPITAL RISK.

4.  ASSET AND LIABILITY STRUCTURE
• ONLY APPLICABLE TO BANKS.
• BASIS RISK- ARISES WHEN THE INTEREST ON ASSETS AND LIABILITIES
ARE CALCULATED ON DIFFERENT BASES.
• EG: BANK LENDS AT 6 MONTHS, LIBOR+1%, WHICH IS FUNDED BY THE
BANK ACCEPTING TERM DEPOSIT.
• AT THE END OF 6 MONTHS, THE BANK EXPECTS TO ROLL OVER BOTH THE
LOAN AND DEPOSIT,
THERE IS A POSSIBLE VARIATION IN LIBOR – IS KNOW AS BASIS RISK.
• GAP EXPOSURE- ARISIES WHEN THE ASSETS AND LIABILITIES MATURE
FOR DIFFERENT PERIODS.
• EG: BANK MAY HAVE COMMITTED FOR 2 YEARS LENDING, BUT FUNDING
MAY BE IN FORM OF TERM DEPOSITS FOR 6 MONTHS, HENCE AT THE TIME
OF RENEWAL OF DEPOSITS THE INTREST RATE MAY VARY.

5.  FINANCIAL SWAPS
• TWO FIRMS IN TWO DIFFERENT MARKETS MAY HAVE A RELATIVE
STRENGTH IN BORROWING IN TWO DIFFERENT CURRENCIES.
• THE SWAP MAY INVOLVE BORROWING AT FLOATING RATE AND
EXCHANGING THE LIABILITY AT FIXED INTEREST RATE.
• BOTH – CURRENCY AND INTEREST RATE FACTORS AFFECT THE CHOICE
OF SWAP.
SWAPS ARE CLASSIFIED INTO 3 TYPES:
 CURRENCY SWAPS - FIRM A, IN NEW YORK CAN BORROW DOLLARS AT
6% AND POUND STERLING AT 9%. FIMR B, IN LONDON CAN BORROW
DOLLARS AT 8% AND STERLING POUND AT 7%.
• HENCE THEY EXCHANGE LIABILITIES.

6.  CROSS-CURRENCY INTEREST RATE SWAP- IS A COMBIANTION OF
CURRECY SWAP AND INTEREST RATE SWAP.
• EG: US FIRM BORROW CHEAP DOLLAR FUNDS AT FLOATING RATE,
EXCHANGE THE LIABILITY WITH UK FIRM WHICH BORROWS STERLING
FUNDS AT CHEAPER RATES AT FIXED RATES OF INTEREST.
• THIS TYPE OF SWAP IS CALLED ‘CIRCUS’ – ‘COMBINED INTEREST RATE
AND CURRENCY SWAP.’
 INTEREST RATE SWAPS-
• IS KNOWN AS THE COUPON SWAP.
• LIABILITIES EXCHANGED ARE - FIXED AND FLOATING RATES OF
INTEREST.
• ZERO COUPON SWAP- WHERE IN, A PARTY CAN MAKE A LUMPSUM
PAYMENT INSTEAD OF PERIODICAL PAYMENT.

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