Interest Rate Risk (IRR)

Published: 2022-12-09
Interest Rate Risk (IRR)
Type of paper:  Essay
Categories:  Company History Society
Pages: 7
Wordcount: 1788 words
15 min read

Interest rate risks can be described as the risks posed by the profitability, and this means that banks are exposed to financial conditions associated with adverse movements and fluctuations in interest rates (Collier & Agyei-Ampomah, 2016). Banks, such as HSBC Holdings face these risks, and below are some of the properties of these risks. a. Sources

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There are three subtypes of interest rate risks faced by HSBC Holdings, gap, basic and optional risks, and the products of different sources (Matic, 2017). The gap risk, to begin with, is a product of changes of HSBC's changes in term structure regarding the instruments of its banking books. To this end, the risk arises when HSBC's structural changes are below the threshold of its productivity as well as performance. This means that the bank will not attain its full operating potential. As with basis risk, the changes in interest rates for HSBC's financial instruments potentiates its occurrence. Normally, this risk will arise when there is an imperfect correlation in HSBC's earned rates of adjustments and those paid of distinct instruments alongside otherwise identical repricing characteristics. Thus, the differences and fluctuations in the rates potentiate unpredictable differences in cash flows as well as earnings that will cut across HSBC's liabilities, assets as well as off-balance-sheet (OBS) items. The options risk, however, is a function of HSBC's optional elements associated with its liabilities, assets as well as off-balance sheet possessions (Matic, 2017). In this part, the risk arises from the fact that HSB has the option, no obligation, to sell, buy or somewhat elucidate alterations in its cash flows about its financial contracts or instruments. The options pertinent in this case include Over-The-Counter (OTC) contracts and the exchange-traded alternative. Whichever is HSBC's choice, some risks will materialize. For instance, insufficient management of these contracts poses challenges and threats when the bank chose to sell any of them. Again, adding more options, the two, in this case, extends the leverages on each of them, and this will affect HSBC's financial condition negatively.


The four significant measurement models for interest rate risks include adjustments in convexities of yield curves, duration, and maturity and lastly, the repricing or gap finding the model (Griffin Mining Limited, 2017). However, the measurement of IRR is a process that begins with data collection at the purchase point, and this includes the bond's prices as well as the coupon rate. For instance, the bond price could be 110 and the coupon 5%. This is then followed by a study on the current prices, as influenced by market factors. Consider a situation where the bond retails at 113 while its interest rates have halved. The following equation will apply in the measurement of the exact figures of the risk.

(Original Price - New Price)/ New Price

Regulatory Infrastructure

There are various regulatory measures for IRR. However, the development of policies and procedures governing credit approval and administration is critical. The policies and procedures developed and put in place manifest through other strategies such as, the strategy of hedging as interest rates swap (Sundaram & Das, 2016). For instance, when one of HSBC's asset's interest rates escalates, its value will drop more than its liability, and this potentiates marked-to-market losses. The regulatory infrastructure can also incorporate regulatory requirements such as accurate documentation of credit activities, and this is meant to incapacitate discrepancies and concurrently facilitate comparison of notes. A typical case is that in which HSBC Interest Rate Risk in the Banking Book (IRRBB) documents assume maturity caps for the non-mature deposits. This can be viewed as a poor image of reality. To this end, the primary objective is ironing the credit services through the restructuring of internal systems, and this allows the issuance of mature loans. Other regulatory infrastructure includes Asset-Liability and Capital Management (ACLM) in which simulation of balance sheets and the bank's net worth is facilitated under the movements of interest rates. In ACLM, there is careful management of the mismatches and disparities between liabilities and assets, and this pre-empts impending risks that HSBC could face.

Liquidity Risk

a. Sources

Liquidity risks are the misfortunes associated with the inability of banks to meet short-term financial requirements or needs. There are various reasons and causes for this, and one of the most common sources that HSBC is most likely t encounter is its inability to convert credit securities into cash or money under the condition that it does not lose any money or income whatsoever (Griffin Mining Limited, 2017). The typical way through which this can happen is when HSBC intends to dispose of one of the credit securities at its disposal, and yet there is no one interest interested in acquiring the particular item. Consider a situation where a client acquired a loan from the bank and issued a parcel of land next to the government road reserve. The client ends up disappearing due to inability to pay back the loan. HSBC may attempt to sell the piece of land. However, finding an individual who will buy the piece of land at an amount equivalent to the market value of the asset on sale becomes difficult.

Liquidities can be categorized into three distinct groups systemic, timing or technical and individual or idiosyncratic, and each of the groups also confers characteristic causes. The systemic liquidity, to begin with, is a risk emanating from the whole market, and is the product of the disrupted market, the inadequate market as well as central bank funding (Adalsteinsson, 2014). Naturally, these are factors that HSBC can neither influence nor tame.

The timing or technical sources of liquidity risks revolve around the technicality of the banking system, especially cash flow issues (Adalsteinsson, 2014). For instance, HSBC can indicate a phenomenon of insufficient liquidity, and yet financial audit of its does not reveal that the bank is the outright source of the risk. This means that the timing could be the issue when HSBC has liquidity. An excellent clarification is a scenario where post large cash inflows over long periods, but short-lived outflows exceeding the bank's liquidity buffers (Adalsteinsson, 2014). Such as scenario mean that HSBC can be fine, from the long-term view. However, it could be at risk from a short-term perspective.

As with the idiosyncratic or individual, the risks could be products of particular, or rather specific reasons within HSBC (Adalsteinsson, 2014). In most cases, they are driven by forces from the general market, and various reasons such as forecast of huge losses or downgrades account for this. To this end, HSBC is neither capable of refinancing its obligations nor attracting new obligations. This differentiates funding risk in which the latter is a situation in which HSBC is incapable of realizing assets due to disrupted market or market insufficiency (Adalsteinsson, 2014).


There are two distinct ways of measuring or rather estimating liquidity risks, balance sheet and cash flow analysis (Adalsteinsson, 2014). As with balance sheet analysis, HSBC will analyze its financial statements so that it can determine its health regarding the risks available. Various analogies are illustrating this. Consider a scenario where an individual buys a house worth "X" in which 80% of this amount is borrowed from HSBC. In this case, the value of the house, X, is equivalent to the sum of the buyers 20% contribution and HSBC's 80% and can be represented by the equation below.

X = 80% + 20%

In this fashion, the individual cannot claim full ownership of the home and suppose the value of the home doubles within a stipulated time like five years. The risk potentiates a large change in HSBC's balance sheet. This is because of the resultant increase in the risk percentage (Adalsteinsson, 2014). Such a phenomenon is arguably a risk triggered by market forces, and as such, is out of HSBC's control.

Typically, organizational cash flows indicate the sources of cash as well as resultant expenditure over define periods, quarterly or annually. This can be a short-term, immediate or long-term measurement. However, the general point cutting across is that analysis of cash flows will reveal HSBC's damages that hinder from meeting both short-term and long-term financial needs (Adalsteinsson, 2014). The primary function of the cash flow statements is indicating the cashflows, regarding the balance sheet positions. This will organize the balance sheet in which cash outflows and inflows are contractually reflected in their maturity bucket. Any mismatches in the process indicate a possible risk that HSBC may not know.

Regulatory Infrastructure

Banks like HSBC cannot rely on the assistance offered by regulators of the financial industry to mitigate issues revolving around liquidity risks. However, several infrastructures can help mitigate liquidity risks. One, HSBC, for instance, should establish a robust management framework for liquidity risks. This framework should define the set of activities ranging from the investigation of the causes as well as appropriate interventions for such risks. For instance, the bank can develop severe testing scenarios for its activities (Adalsteinsson, 2014). In this dimension, the bank will probably predict an imminent risk and consequently, develop prophylaxis. For instance, if the framework assist HSBC detect an onset in the outflows and inflows of its investments, the bank may resort to putting that particular investment on hold. Other infrastructures include the establishment of vibrant contingency plans for funding of the bank's activities, maintenance of liquidity risks so that they do not surpass the bank's ability to handle as well as promoting a general trend of market discipline through disclosing its risk issues to the public (Adalsteinsson, 2014). While some of these infrastructure targets HSBC's particular activities, like fires, fraud, and lawsuits, potentiating risks, there market-specific infrastructure targeting market-derived risks such as commodity prices, exchange rates and changes in interest rates Collier & Agyei-Ampomah, 2016).

Operational Risk (OR)

Most banks like HSBC link OR to liquidity risks and the explanation behind it is that it arises from internal factors such as errors, interruptions, and breaches Collier & Agyei-Ampomah, 2016). A typical example of operational risk at HSBC unfolds at the contact point with the bank's clients, and the installed autonomous systems are the major triggers (Loader, 2011). In this part, the three significant risks that may occur are catastrophic, unique alongside creeping risks. The latter unfolds when there issues to do with the transaction charges. The risks' severity depends on the extent to which the changes in transitional charges manifest and this is because it determines the extent to which HSBC's clients will lodge complaints regarding the changes. Catastrophic risks, on the other hand, are severe risks that may potentiate the closure or collapse of the bank such as investing in unviable business ventures. Lastly, unique risks are those emanating from HSBC's resource levels such as structure, and sets of skills (Loader, 2011). The comprehensive manifestation of these risks come out in the form of controls and compliance failures, external and internal fraud, inefficient processes as well as confidentiality issues regarding client information.

a. Sources

There are external and internal sources of operational r...

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