Interest Rate Risk

Interest Rate Risk: The Seesaw of Money 🎢

Imagine you’re on a playground seesaw. When one side goes up, the other goes down. Interest rates and bond prices work exactly the same way!

What is Interest Rate Risk?

Picture this: You have a piggy bank that pays you a fixed amount of candy every month. But suddenly, the candy shop starts offering MORE candy for the same money. Your old piggy bank doesn’t look so great anymore, right?

That’s Interest Rate Risk in a nutshell!

Simple Definition: Interest Rate Risk is the danger that your investments lose value when interest rates change.

Real Life Example 🍭

• You buy a bond that pays you 5% per year
• Next year, new bonds pay 7% per year
• Nobody wants your old 5% bond anymore!
• To sell it, you must accept a lower price

graph TD
    A["Interest Rates GO UP ⬆️"] --> B["Bond Prices GO DOWN ⬇️"]
    C["Interest Rates GO DOWN ⬇️"] --> D["Bond Prices GO UP ⬆️"]

Why Does This Happen?

Think of it like music players:

• You bought an MP3 player for $100
• Next week, a BETTER player comes out for $100
• Your old player is now worth less!

The same thing happens with bonds and loans.

Gap Analysis: Counting Your Mismatched Toys 🧮

The Story of Two Piggy Banks

Imagine you have:

• Piggy Bank A: Opens in 1 month (gives you money SOON)
• Piggy Bank B: Opens in 1 year (gives you money LATER)

If interest rates change, these two piggy banks react DIFFERENTLY!

Gap Analysis = Counting the difference between things that react FAST vs SLOW to interest rate changes.

How Banks Use Gap Analysis

Banks have:

• Assets (money they will RECEIVE) 💰
• Liabilities (money they will PAY) 💸

Understanding the Gap

graph TD
    A["Positive Gap +20M"] --> B["More assets than liabilities repricing"]
    B --> C["If rates GO UP = GOOD for bank! 🎉"]
    B --> D["If rates GO DOWN = BAD for bank 😟"]

    E["Negative Gap -20M"] --> F["More liabilities than assets repricing"]
    F --> G["If rates GO UP = BAD for bank 😟"]
    F --> H["If rates GO DOWN = GOOD for bank! 🎉"]

Simple Example 🏠

Your Lemonade Stand Bank:

• You BORROW $100 that changes rate every month (liability)
• You LEND $100 that stays fixed for a year (asset)

Gap = Fixed Asset - Variable Liability = MISMATCH!

If rates go up:

• You pay MORE on your borrowing 😢
• You receive the SAME on your lending
• You LOSE money!

Duration and Convexity: How Bouncy is Your Ball? 🏀

Duration: The Sensitivity Meter

Think of Duration like asking: “How much will my investment bounce around when interest rates change?”

Duration tells you: For every 1% change in interest rates, how much will my bond’s price change?

The Ruler Analogy 📏

Imagine bonds are rulers of different lengths:

• Short ruler (2 years duration): Small bounce when rates change
• Long ruler (10 years duration): BIG bounce when rates change

Why Duration Matters

graph TD
    A["Higher Duration"] --> B["More Sensitive"]
    B --> C["Bigger Price Swings"]
    C --> D["More Risk AND More Reward"]

    E["Lower Duration"] --> F["Less Sensitive"]
    F --> G["Smaller Price Swings"]
    G --> H["Less Risk AND Less Reward"]

Convexity: The Curve Ball 🎱

Duration isn’t perfect! It assumes the seesaw moves in a straight line. But in real life, it curves!

Convexity measures how the curve bends—like a slide, not a straight line.

The Slide vs The Ramp

• No Convexity: Like a straight ramp—predictable
• With Convexity: Like a curved slide—prices fall slower but rise faster!

Why This is GOOD:

• When rates GO UP → You lose LESS than expected
• When rates GO DOWN → You gain MORE than expected

Real Example 🎯

Bond A vs Bond B (both 5-year duration):

Bond B wins both ways! That’s the magic of convexity.

Repricing Risk: When Your Price Tag Changes 🏷️

The Ice Cream Shop Story 🍦

Imagine you run an ice cream shop:

• You BORROW money that changes price every month
• But your ice cream prices only change once a YEAR

What happens when borrowing costs go up?

• Your costs rise FAST
• Your income stays the SAME
• You’re in trouble!

Repricing Risk = The danger that your costs and income don’t change at the same time.

How Repricing Works

graph TD
    A[Bank's Assets and Liabilities] --> B{When do they reprice?}
    B --> C["Same time = LOW Risk ✅"]
    B --> D["Different times = HIGH Risk ⚠️"]

Types of Repricing Mismatches

1. Timing Mismatch ⏰

• Deposits reprice in 1 month
• Loans reprice in 6 months
• GAP = 5 months of danger!

2. Amount Mismatch 💵

• $100M deposits repricing this month
• Only $50M loans repricing this month
• $50M is exposed to rate changes!

Real Bank Example 🏦

Analysis:

• In the first month, $100M deposits will reprice
• But only a small portion of loans reprice
• If rates rise, the bank pays MORE but earns the SAME!

Protecting Against Repricing Risk

1. Match your timings ⏰

   • If deposits reprice monthly, make loans reprice monthly too

2. Use hedging tools 🛡️

   • Interest rate swaps
   • Futures contracts

3. Diversify repricing dates 📅

   • Don’t have everything reprice at once!

Putting It All Together 🧩

The Complete Picture

graph TD
    A["Interest Rate Risk"] --> B["Gap Analysis"]
    A --> C["Duration & Convexity"]
    A --> D["Repricing Risk"]

    B --> E["Measure timing mismatches"]
    C --> F["Measure price sensitivity"]
    D --> G["Manage when rates reset"]

    E --> H["Lower Risk!"]
    F --> H
    G --> H

Quick Summary

Remember This! 🌟

1. When rates go UP, bond prices go DOWN
2. Longer duration = More sensitive to rate changes
3. Higher convexity = Better protection
4. Matched repricing = Lower risk
5. Gap Analysis helps banks plan ahead

You’re Now an Interest Rate Risk Expert! 🎓

You’ve learned how banks and investors think about one of the most important risks in finance. The seesaw of interest rates affects everyone—from big banks to your savings account!

Key Takeaway: Understanding these concepts helps you make smarter decisions with your money and understand why banks do what they do.

Keep learning, keep growing, and remember—even complex finance is just everyday concepts in disguise! 🚀