Chapter 3

Interest Rate Risk Introduction and Overview

Interest rate risk is at the heart of every silo of truly integrated risk management: credit risk, market risk, asset and liability management (ALM), liquidity risk, performance measurement, and even operational risk. Credit risk analysis that is not built on a random interest rate risk framework completely misses one of the key macroeconomic factors driving default. This is even truer when credit risk omits explicit modeling of a key macroeconomic factor such as home prices. Both interest rates and home prices, as predicted by Jarrow et al. (2003) in the FDIC Loss Distribution Model, are critical drivers of correlated bank defaults as the $1 trillion bailout of the U.S. savings and loan industry in the 1980s and 1990s and the $1 trillion bailout of the U.S. “too big to fail” institutions in 2008 and 2009 confirms. Market risk at most institutions includes a large proportion of fixed income instruments, so we have to deal with interest rate risk in a comprehensive way to deal with market risk. Asset and liability management at most institutions involves both sides of the balance sheet and a range of instruments with complexities that go far beyond those found in market risk, such as pension liabilities, insurance policies, nonmaturity deposits, credit card advances, and so on. Analysis of each of these instruments must be based on a random interest rate framework as well. In ALM, the complexity of the task is aggravated by ...

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