Interest Rate Risk-3

Objective
The objective of the session is to comprehend
the following variants of interest rate risk.
Price Risk.

Reinvestment risk
Price Risk
The values of investments change inversely to
interest rates.
If the interest rate in the market increase,
investment suffer depreciation.
If the interest rate decline, investments in the
banks portfolio gain in value.
The price change in investments are on account
of the present values of the cash flows in the
bond being altered when discounted by the new
interest rate.

Price Risk
Thus all bonds are subject to price risk which
is the potential loss in value on account of
changes in interest rates.
This concept can be generalized and can be
extended to all items of assets and liabilities in
a banks balance sheet which conceptually
constitutes series of expected cash flows.
As such ,have present values (market values
)which vary with market interest rates.
Price Risk
Thus all items of assets and liabilities are
exposed to price risk.
Price risk will impact the values of assets and
liabilities of bank .
In turn impact market value of net worth
which is the difference between the market
value of assets and liabilities.

Reinvestment risk
The expected yield on investments, generally
indicated by yield to maturity.
It is based on the important assumption that the
bond will be held till maturity
It is also assumed that during the life of the bond,
the periodic coupons received will be reinvested
at an interest rate equal to the YTM.
This assumption can go wrong in which case
income from investments by way of coupons gets
reinvested at lower rates in case the interest rates
decline.
Reinvestment Risk
Uncertainty with regard to interest rate at which the future
cash flows can be reinvested is called reinvestment risk.
The bond pricing formula assumes that all coupon
payments are reinvested at the bonds Yield to
Maturity.(YTM).
However in reality the interest rates can never be static in
the market.
Nevertheless as the coupon payments are to be reinvested
for shorter maturity than the original tenure of the bond
(to synchronize with the maturity of the Bond ),the interest
rates for such remaining tenure would be naturally
different from the interest rates (YTM) originally estimated.
Reinvestment Risk
If the interest rate goes up in the market during the life of a bond ,interest
flows will be reinvested at higher yields thereby increasing the
reinvestment income. The increase in reinvestment income will increase
the realized yield of the bond which would be more than the YTM
expected at the time of purchase of the Bond.
On the other hand, when the interest rate declines during the life of the
Bond, the coupons will be reinvested at lower yields which reduce the
reinvestment income. This would result in reduction in realized yield of
the Bond which would be less than the YTM originally estimated at the
time of purchase.
However as the Price of the Bond is inversely proportion to the interest
rates, the bond price would depreciate in the rising interest rate scenario
and bond price would appreciate in the falling interest rate scenario. This
depreciation or appreciation in bond price would result in a capital loss
gain thereby partially setting off the increased reinvestment income or
reduced reinvestment income in the respective scenarios.
Thus price risk and reinvestment risk partially off set one another.