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Interest rate risk

Interest rate risk is the potential for losses in the value of assets, liabilities, or future cash flows due to adverse movements in interest rates. While it applies broadly to any interest-sensitive positions, such as bonds or loans, it is particularly critical for financial institutions, where it can adversely impact earnings, capital, and overall financial condition.^[1] This risk primarily affects the value of assets, liabilities, and off-balance-sheet positions, as well as cash flows from interest-sensitive activities, and is a fundamental aspect of banking operations where mismatches between rate-sensitive assets and liabilities can lead to volatility in net interest income.^[2] IRR manifests in several key forms, including repricing risk, which stems from differences in the timing of interest rate changes and the repricing or maturity of assets and liabilities; basis risk, arising from imperfect correlations in rate adjustments across different market indexes or yield curves; yield curve risk, due to non-parallel shifts in the yield curve across maturities; and options risk, resulting from embedded or explicit options that allow parties to alter the timing or amount of cash flows, such as loan prepayments or deposit withdrawals.^[2] In the context of the banking book, IRR in the banking book (IRRBB) specifically captures the current or prospective risk to capital and earnings from adverse rate movements affecting non-trading positions, excluding trading book activities.^[3] Effective management of IRR is essential for maintaining financial stability, as excessive exposure can threaten liquidity, solvency, and profitability, particularly in environments of low or rising rates.^[1] Regulatory frameworks, such as those from the Basel Committee, require banks to establish robust governance, measure IRR using economic value of equity (EVE) and earnings-based approaches under standardized shock scenarios (e.g., parallel shifts of ±200 basis points under the current 2016 framework, with currency-specific recalibrations effective January 2026 such as ±275 basis points for USD), and disclose exposures to ensure supervisory oversight and capital adequacy.^[3]^[4] Institutions typically mitigate IRR through asset-liability management strategies, including hedging with derivatives, diversification of funding sources, and stress testing to align risk with board-approved appetites.^[2]

Fundamentals

Definition and Overview

Interest rate risk refers to the potential for financial losses arising from adverse changes in interest rates that affect the value of financial instruments, such as bonds, loans, and other fixed-income securities, or the future cash flows of institutions and investors.^[5] This risk materializes when rising interest rates decrease the present value of future cash inflows or increase borrowing costs, while falling rates can have the opposite effect, though the impact is often asymmetric due to the nature of most financial contracts.^[6] In essence, it encompasses both market value changes in existing assets and liabilities and earnings volatility from mismatches in rate-sensitive positions.^[1] The recognition of interest rate risk as a critical financial concern emerged prominently in the 1970s, following the deregulation of interest rates in major economies like the United States, where high inflation eroded the effectiveness of fixed rate ceilings on deposits under Regulation Q.^[7] This led to the Depository Institutions Deregulation and Monetary Control Act of 1980, which phased out interest rate controls and exposed banks and thrifts to greater market-driven rate fluctuations, culminating in widespread failures during the savings and loan crisis of the 1980s.^[8] Prior to deregulation, controlled rates had insulated institutions from volatility, but post-1970s shifts made interest rate risk a core element of financial stability oversight.^[9] At its core, interest rates represent the cost of borrowing money or the return on lending, influencing economic decisions across households, businesses, and governments.^[10] They exhibit an inverse relationship with the present value of future cash flows: as rates rise, the discounted value of those flows declines, and vice versa, due to the time value of money. This relationship is captured by the basic present value formula for a single future cash flow:

PV = \frac{FV}{(1 + r)^n}

where PV is the present value, FV is the future value, r is the interest rate per period, and n is the number of periods.^[11] For instance, fixed-rate instruments like traditional bonds lock in payments at issuance, making their market value highly sensitive to rate changes, whereas floating-rate instruments, such as adjustable-rate mortgages or floating-rate notes, periodically reset payments based on prevailing rates, thereby reducing price volatility but exposing holders to uncertain future income streams.^[12]^[13]

Bond Price Sensitivity to Interest Rates

Bond prices and interest rates exhibit an inverse relationship, such that when market interest rates rise, the prices of existing fixed-rate bonds fall, and conversely, falling rates lead to rising bond prices.^[14] This occurs because bonds typically pay fixed coupon rates, and when prevailing market rates increase, the bond's fixed payments become less attractive relative to new bonds issued at higher rates, prompting investors to demand a discount on the existing bond's price to achieve a comparable yield.^[15] The pricing mechanism relies on discounting future cash flows: higher discount rates reduce the present value of these fixed payments, lowering the bond's overall value.^[14] The fundamental equation for a bond's price illustrates this sensitivity:

P = \sum_{t=1}^{T} \frac{C}{(1 + y)^t} + \frac{F}{(1 + y)^T}

Here, P is the bond price, C is the periodic coupon payment, F is the face value, T is the time to maturity in periods, and y represents the yield to maturity, serving as a proxy for prevailing market interest rates.^[16] An increase in y raises the denominators, compressing the present value of both coupons and principal, which directly diminishes P.^[16] Graphically, the relationship between bond prices and yields forms a convex curve, sloping downward from left to right: as yields rise from low levels, prices decline at a decreasing rate due to the compounding effect on distant cash flows.^[17] This convexity implies that for equal changes in yield, the percentage price increase from a yield decline exceeds the percentage price decrease from a yield rise, providing a cushion against rate hikes but amplifying gains from rate drops.^[17] Zero-coupon bonds, which pay no periodic interest and return only the face value at maturity, exhibit greater price sensitivity to interest rate changes compared to coupon-paying bonds of the same maturity.^[18] This heightened sensitivity arises because all value is concentrated in the distant principal repayment, making longer-maturity zero-coupon bonds particularly vulnerable to rate fluctuations, as small yield changes have a pronounced impact on the discounted terminal value.^[18] In contrast, coupon bonds receive interim payments that partially offset price volatility through reinvestment opportunities.^[18] A historical illustration of this dynamic occurred during the 1981 U.S. interest rate spike, when Federal Reserve Chair Paul Volcker's aggressive anti-inflation policy drove the federal funds rate to nearly 20% and the 10-year Treasury yield above 15%.^[19] As a result, long-term bond prices plummeted; for instance, 30-year Treasury bonds traded at around 92 (below par value of 100) amid yields hitting 15%, reflecting substantial market losses for bondholders.^[20]

Types of Interest Rate Risk

Repricing Risk

Repricing risk, also known as mismatch risk, arises from differences in the timing of interest rate resets or maturities between a financial institution's assets and liabilities, potentially leading to adverse changes in net interest income.^[21] This form of interest rate risk primarily affects earnings when rate-sensitive assets and liabilities reprice at different times or by different amounts in response to market rate changes.^[22] For instance, if interest rates rise, institutions with more liabilities repricing sooner than assets may face increased funding costs before income from assets adjusts, compressing margins.^[23] Gap analysis serves as a common method to quantify repricing risk by calculating the difference between rate-sensitive assets (RSA) and rate-sensitive liabilities (RSL) within specific time periods, known as buckets.^[24] RSA include assets such as variable-rate loans or securities that mature or reprice within a given bucket, while RSL encompass deposits or borrowings that adjust similarly; the gap is computed as RSA minus RSL for each bucket, such as 0-3 months, 3-12 months, or 1-5 years.^[22] A positive gap (RSA > RSL) indicates asset sensitivity, where rising rates boost net interest income, whereas a negative gap (RSL > RSA) signals liability sensitivity, heightening vulnerability to rate increases.^[21] This static approach assumes parallel shifts in rates and equal adjustments in RSA and RSL volumes, though it can be extended with simulations for more dynamic assessments.^[23] A representative example involves a bank funding long-term fixed-rate loans primarily with short-term variable-rate deposits, creating a negative gap in the short-term bucket.^[25] If interest rates rise by 200 basis points, the bank's deposit costs increase immediately, while loan yields remain unchanged until maturity or rollover, potentially reducing net interest margin by several percentage points and eroding profitability.^[26] During the 2008 financial crisis, repricing risk was amplified through widespread funding gaps, as banks' reliance on short-term wholesale funding for longer-term assets exposed them to sudden liquidity strains and repricing pressures when interbank markets froze and funding costs spiked.^[27] This mismatch contributed to broader systemic vulnerabilities, forcing institutions to curtail lending and seek central bank interventions to bridge the gaps.^[28]

Yield Curve Risk

Yield curve risk refers to the exposure arising from non-parallel shifts in the term structure of interest rates, where changes in yields do not occur uniformly across different maturities, altering the shape or slope of the yield curve.^[23] This risk materializes when interest rates at various points along the curve move differently, such as short-term rates rising faster or slower than long-term rates, impacting the relative pricing of bonds with varying maturities.^[26] Common types of yield curve shifts include steepening, flattening, and humped formations. In a steepening shift, long-term rates increase more than short-term rates, widening the spread between them and often occurring during periods of economic recovery or tightening monetary policy.^[29] Flattening happens when short-term rates rise relative to long-term rates or long-term rates decline, narrowing the spread and signaling potential economic slowdowns.^[23] A humped curve emerges when medium-term yields exceed both short- and long-term yields, typically reflecting transitional uncertainty in monetary policy or inflation expectations.^[30] These non-parallel shifts pose significant challenges to portfolios with mismatched maturities, as they can lead to uneven valuation changes across holdings. For instance, a barbell portfolio—concentrated in short- and long-term bonds—may underperform a bullet portfolio—focused on intermediate maturities—during a steepening, where the rise in long-term rates disproportionately erodes the value of the longer-duration legs.^[29] Conversely, in a flattening scenario, the barbell strategy might benefit from stable or declining long-term rates but suffer if short-term liabilities reprice higher, amplifying losses for institutions with duration mismatches.^[31] Such twists highlight the vulnerability of concentrated or unbalanced fixed-income positions to curve distortions beyond simple parallel movements. A notable historical example is the 1994 bond market massacre, triggered by the Federal Reserve's series of interest rate hikes starting in February 1994, which raised the federal funds rate from 3% to 6% over the year. These hikes led to a bear steepening of the yield curve, with 10-year Treasury yields surging from approximately 5.2% in late 1993 to around 8% by November 1994, causing peak-to-trough losses of over 20% in U.S. bond futures and widespread portfolio devaluations globally. The event underscored how unexpected policy tightening can exacerbate yield curve risk, particularly for long-duration bondholders unprepared for non-uniform rate increases.^[32]

Basis Risk

Basis risk arises from imperfect correlations in the adjustment of interest rates for financial instruments that reference different but related interest rate indices or benchmarks, even if they have similar maturities.^[3] This occurs when the spread between these rates changes unexpectedly, affecting the net interest margin or value of hedged positions. For example, a bank might fund floating-rate loans tied to the London Interbank Offered Rate (LIBOR) with deposits benchmarked to the federal funds rate; if the LIBOR-federal funds spread widens during market stress, the bank's funding costs could rise relative to asset yields, eroding profitability.^[21] Basis risk is particularly relevant in transition periods, such as the shift from LIBOR to risk-free rates like the Secured Overnight Financing Rate (SOFR), where mismatches in fallback provisions or rate adjustments can introduce ongoing exposure.^[33] Institutions measure basis risk through techniques like principal component analysis of historical spread movements or scenario testing of differential rate shocks across benchmarks. Effective mitigation involves aligning reference rates where possible or using basis swaps to hedge spread volatility.^[2]

Options Risk

Options risk stems from embedded or explicit options in financial instruments that allow counterparties to alter the timing, amount, or nature of cash flows in response to interest rate movements, introducing asymmetry in risk exposure.^[2] Common examples include prepayment options in mortgage-backed securities, where borrowers refinance loans during falling rates, shortening asset durations and reducing expected yields; or early withdrawal options in non-maturity deposits, which can lead to unexpected outflows in rising rate environments.^[34] This risk affects both earnings and economic value, as options can cap upside potential while exposing institutions to downside volatility. For instance, in a low-rate environment, the value of call options embedded in liabilities (e.g., callable deposits) may increase, prompting withdrawals that force reinvestment at lower rates. Measurement often involves option-adjusted spread (OAS) models or Monte Carlo simulations to capture the non-linear impacts under various rate scenarios.^[23] Banks manage options risk by limiting concentrations in option-embedded products, incorporating behavioral assumptions in modeling, and hedging with interest rate options like caps or floors.^[35]

Measurement Techniques

Duration

Duration serves as the foundational metric for assessing a bond's sensitivity to changes in interest rates, quantifying the weighted average timing of its cash flows and approximating the percentage change in price for a given shift in yields. Introduced by Frederick R. Macaulay in 1938, it provides a single number that captures the time horizon over which a bond's payments are expected, making it essential for understanding interest rate risk in fixed-income portfolios.^[36]^[37] Macaulay duration, often simply referred to as duration, is calculated as the present value-weighted average of the times until each cash flow is received. For a bond with price P, periodic coupon payments C, yield per period y, and final principal F at maturity T periods, the formula is:

D = \frac{1}{P} \sum_{t=1}^{T} t \cdot \frac{C}{(1 + y)^t} + T \cdot \frac{F}{(1 + y)^T}

This measure, expressed in years, reflects the bond's effective maturity adjusted for the timing and size of all payments.^[36]^[38] Modified duration builds on Macaulay duration to directly estimate price volatility, defined as the Macaulay duration divided by (1 + y), where y is the yield per period. It approximates the percentage change in bond price for a small change in yield: \frac{\% \Delta P}{ \Delta y} \approx -D_{\text{mod}}, or \% \Delta P \approx -D_{\text{mod}} \cdot \Delta y. For small yields, it is sometimes approximated using Macaulay duration as \% \Delta P \approx -D_{\text{mac}} \cdot \Delta y. This adjustment makes it a direct sensitivity measure, with higher values indicating greater price responsiveness to rate changes.^[36]^[38]^[39] While powerful, duration relies on key assumptions that limit its accuracy: it presumes parallel shifts across the yield curve and small yield changes, providing only a linear (first-order) approximation of price movements that can deviate for larger or non-parallel shifts.^[40]^[41] For illustration, consider a 10-year bond with a 5% annual coupon rate trading at par under a 5% yield; its Macaulay duration is approximately 7.9 years and modified duration approximately 7.5 years, implying that a 1% increase in yield would reduce the bond's price by about 7.5% using the modified duration approximation.^[42]^[43]

Convexity and Key Rate Duration

Convexity extends the duration measure by accounting for the non-linear relationship between bond prices and interest rate changes, capturing the curvature in the price-yield curve through the second derivative of the bond price with respect to yield.^[44] Mathematically, for a bond with cash flows C_t at times t, price P, and yield y, convexity C is given by

C = \frac{1}{P} \sum_{t=1}^{T} \frac{t(t+1) C_t}{(1 + y)^{t+2}},

where T is the number of periods.^[45] This measure refines the price change approximation for larger yield shifts, where the percentage change in price \% \Delta P is estimated as \% \Delta P \approx -[D](/page/Duration) \Delta y + \frac{1}{2} C (\Delta y)^2, with D denoting duration; the quadratic term adjusts for the convexity effect, improving accuracy over linear duration alone.^[46] For most traditional bonds, convexity is positive, meaning the price-yield curve is upward-curving, which provides a cushion against price declines during interest rate increases and enhances gains during decreases.^[47] This beneficial asymmetry arises because, for a given yield change, the price appreciation from falling rates exceeds the depreciation from rising rates.^[44] Key rate duration, introduced by Thomas Ho in 1992, decomposes a security's interest rate sensitivity into exposures at specific points along the yield curve, allowing for analysis of risks from non-parallel shifts.^[48] Unlike effective duration, which assumes uniform curve movements, key rate duration measures the price sensitivity to a 1 basis point change in a particular key rate (e.g., the 2-year or 10-year spot rate) while keeping other rates fixed via interpolation, typically using a set of predefined maturity nodes like 3 months, 2 years, 5 years, 10 years, and 30 years.^[49] The sum of key rate durations across all nodes equals the bond's total effective duration, providing a granular view of curve-specific risks.^[50] An important application involves mortgage-backed securities (MBS), which often exhibit negative convexity due to embedded prepayment options; as rates fall, homeowners refinance, shortening the security's effective maturity and limiting price upside, while rising rates extend duration without offsetting prepayments, amplifying downside risk.^[51] This negative convexity, akin to a short call option position, can lead to underperformance in volatile rate environments compared to positively convex instruments.^[52]

Management Strategies

Hedging with Derivatives

Interest rate derivatives provide a primary mechanism for hedging interest rate risk by allowing market participants to offset exposures in fixed-income instruments or liabilities through standardized contracts traded on exchanges or over-the-counter markets. These instruments enable precise adjustments to interest rate sensitivity, often targeting duration as a measure of price volatility to interest rate changes.^[53] Interest rate swaps are among the most commonly used derivatives for this purpose, involving agreements between two parties to exchange fixed-rate payments for floating-rate payments, or vice versa, based on a notional principal amount. In a typical fixed-for-floating swap, the fixed-rate payer locks in a predetermined rate to hedge against rising interest rates on floating-rate liabilities, such as variable-rate loans, by receiving floating payments that offset increases in funding costs.^[54] Conversely, a floating-for-fixed swap (or receiver swap) can hedge fixed-rate assets against falling rates by converting them to floating exposure.^[23] These swaps are particularly effective for managing long-term exposures, as they can be tailored to match the maturity and cash flows of the underlying position, thereby reducing repricing and basis risks.^[53] Futures contracts, such as Three-Month SOFR futures, offer a standardized way to hedge short-term interest rate risk, with each contract based on the three-month SOFR rate.^[55] A short position in Three-Month SOFR futures protects against rising short-term rates by profiting from the resulting decline in futures prices, effectively capping borrowing costs for entities with upcoming floating-rate resets. Options on interest rates, including caps and floors, provide asymmetric protection; a cap consists of a series of call options on a reference rate (e.g., SOFR), paying the holder the excess of the rate over a strike level, thus limiting upside risk for floating-rate payers.^[2] Floors, conversely, use put options to safeguard against rate declines, ensuring minimum yields for floating-rate receivers, though they involve premium costs that must be weighed against the potential benefits.^[2] Swaptions extend this flexibility by granting the holder the right, but not the obligation, to enter into an interest rate swap at a specified future date and fixed rate, allowing for conditional hedging strategies. A payer swaption, for instance, provides the option to pay fixed and receive floating, ideal for hedging anticipated future borrowing needs when rates are expected to rise, while offering the ability to forgo the swap if rates fall.^[56] This optionality is valuable for managing convexity in portfolios where interest rate movements may nonlinearly affect values, enabling cost-effective adjustments without committing to a full swap upfront.^[56] For example, a portfolio manager holding a bond portfolio with a duration of 7 years might hedge against rising rates by selling Treasury note futures contracts, whose durations (typically 4-7 years for eligible bonds) can be scaled to match the portfolio's exposure; if rates increase by 1%, the gain on the short futures position offsets the approximate 7% decline in bond values.^[57] This approach leverages the high liquidity of Treasury futures to achieve an effective duration-neutral hedge.^[57]

Asset-Liability Management

Asset-liability management (ALM) is a structured process employed by financial institutions to identify and mitigate mismatches between the interest rate sensitivities of assets and liabilities, thereby reducing exposure to interest rate fluctuations. This involves conducting gap analyses to measure differences in repricing or maturity profiles, such as calculating the repricing gap as the difference between rate-sensitive assets and liabilities over specific time horizons.^[2] Immunization strategies, a core component of ALM, aim to align these sensitivities to protect the economic value of equity from adverse rate movements, often by matching the duration of assets to that of liabilities to ensure that changes in interest rates affect both sides of the balance sheet proportionally.^[25] Such approaches address repricing risk by minimizing the impact of short-term rate changes on net interest income.^[58] Key techniques in ALM for immunizing portfolios include cash flow matching, also known as dedication, which involves selecting assets whose cash inflows precisely correspond to projected liability outflows, typically using fixed-income securities like bonds to fund liabilities at predetermined times without reinvestment risk.^[58] This method ensures that liabilities are met from dedicated asset streams, eliminating interest rate risk for those matched flows, though it requires accurate forecasting of liability timings and may limit portfolio flexibility.^[2] Contingent immunization complements this by allowing active portfolio management to pursue higher returns as long as the portfolio value remains above a safety threshold, at which point it shifts to a full immunization strategy like duration matching to guarantee minimum returns.^[58] These techniques prioritize balance sheet stability over aggressive yield-seeking, particularly in volatile rate environments. Financial institutions utilize simulation models, such as Monte Carlo methods, as essential tools within ALM to stress test interest rate scenarios and evaluate potential impacts on asset-liability gaps.^[59] These models generate thousands of probabilistic paths for interest rates, incorporating factors like volatility and correlations, to simulate outcomes for earnings and economic value under various shocks, enabling institutions to adjust strategies proactively.^[2] For instance, pension funds often rebalance their asset portfolios through duration matching to align with long-term liability durations during periods of rate volatility, such as when falling rates increase liability values; by investing in fixed-income assets with equivalent durations, funds offset these increases with corresponding asset gains, maintaining funded status stability.^[60]

Impacts on Financial Institutions

Banks

Banks primarily encounter interest rate risk through mismatches between the maturities of their assets and liabilities, where longer-term fixed-rate loans serve as assets while shorter-term deposits act as liabilities that can reprice more frequently.^[35] This maturity transformation exposes banks to repricing risk, a component of interest rate risk, as changes in market rates can alter the relative costs and yields of these positions.^[2] For instance, when interest rates rise, the yields on existing loans may remain fixed, while deposit rates adjust upward, compressing net interest margins.^[61] To quantify this exposure, banks use Earnings at Risk (EaR), a simulation-based metric that estimates the potential impact of interest rate changes on net interest income (NII) over a short-term horizon, typically one to two years.^[2] EaR models incorporate the bank's balance sheet data, projected rate scenarios, and behavioral assumptions for deposit runoff or loan prepayments to forecast earnings volatility.^[62] This approach helps identify vulnerabilities in NII under rate shocks, emphasizing the need for ongoing monitoring. Interest rate risk in banks also intersects with liquidity management, as rising rates can elevate funding costs by prompting depositors to seek higher yields elsewhere, thereby increasing reliance on more expensive wholesale funding sources.^[25] In such environments, banks may face deposit outflows, straining liquidity buffers and forcing higher interest payments to retain or replace funds, which further erodes profitability.^[2] This dynamic was evident during periods of rate hikes, where funding costs rose disproportionately for institutions with sticky low-rate deposits.^[63] The impacts of rising rates became particularly acute in 2023, contributing to the failures of regional banks such as Silicon Valley Bank, where unrealized losses on long-duration securities portfolios amid rapid Federal Reserve rate hikes led to liquidity crises and depositor runs.^[64] Higher funding costs continued to compress net interest margins (NIM) in 2023-2024, with community banks reporting a NIM of 3.33% in 2024, down from 3.39% in 2023.^[65] As of late 2025, anticipated rate declines in stress scenarios (e.g., short-term rates falling to 0.1%) could provide some relief but also introduce reinvestment risks.^[66] Following the 2008 financial crisis, European banks grappled with negative interest rates introduced by the European Central Bank in 2014, which challenged profitability by inverting traditional net interest margins and imposing costs on excess reserves.^[67] These policies led to compression in bank net interest income, though overall profitability impacts were limited due to offsetting positive effects from increased lending volumes.^[68] Despite mitigative measures like tiered reserve remuneration, negative rates amplified earnings pressures for banks with significant deposit bases.^[69]

Insurance Companies

Insurance companies face significant interest rate risk primarily through mismatches between their asset portfolios, which often consist of fixed-income securities like bonds, and their long-term liabilities, such as fixed annuities and guaranteed benefits. Fixed annuities involve insurers guaranteeing policyholders a predetermined interest rate on premiums invested over extended periods, typically 10-30 years, exposing the company to reinvestment risk when interest rates decline. In low-rate environments, insurers must reinvest maturing assets at lower yields, which can erode the spread between investment returns and the guaranteed crediting rates, compressing profitability and potentially straining reserve adequacy. Similarly, guarantees embedded in products like variable annuities—such as guaranteed minimum accumulation benefits (GMAB) or withdrawal benefits (GMWB)—become more costly as rates fall, since the present value of future payouts rises while asset values supporting those guarantees yield less income.^[70]^[71] A key aspect of this exposure stems from embedded options in insurance contracts, particularly policyholder behavior such as lapses or surrenders, which introduce convexity risks. When interest rates rise, policyholders are more likely to lapse policies to pursue higher-yielding alternatives elsewhere, effectively shortening the duration of liabilities in a non-linear fashion. This dynamic lapse behavior creates negative convexity, where the sensitivity of liability cash flows to rate changes amplifies losses: rising rates devalue fixed-income assets while simultaneously reducing the effective duration of liabilities due to increased lapses, leading to an asset-liability mismatch. Conversely, in falling rate scenarios, lower lapse rates extend liability durations, heightening the present value of obligations. Insurers model this using dynamic lapse assumptions, often calibrated to competitive spreads exceeding 100 basis points, to quantify the convexity effect through stress testing.^[72]^[73] Low interest rate environments particularly challenge solvency metrics by inflating the required reserves and capital for life insurers. Reserves must cover the higher present value of long-term liabilities, such as annuity payouts, while diminished investment income from assets reduces surplus capital; for instance, the industry-wide spread between net yields and crediting rates compressed from 1.1% in 2018 to 0.63% in 2020, prompting shifts toward riskier assets like collateralized loan obligations to maintain returns.^[70] This can lower solvency ratios under frameworks like Solvency II, where prolonged low rates have squeezed profit margins and increased exposure to illiquid or higher-yield investments, though cash flow testing generally ensures coverage. An additional $18.6 billion in reserves was required across U.S. life insurers in 2020 due to such mismatches.^[70]^[74] A notable example occurred in the UK in 2022, when sharp interest rate hikes led to substantial mark-to-market losses for life insurers on their bond holdings and related derivatives. The rapid rise in yields devalued fixed-income portfolios, resulting in unrealized losses estimated at 1-2% of total assets for affected firms, compounded by repricing of liability-driven hedging strategies under Solvency II regulations. This episode highlighted vulnerabilities in insurers with large sovereign bond exposures (10-20% of portfolios), triggering liquidity strains from margin calls on interest rate swaps and futures positions.^[75] Following rate hikes through 2023, U.S. and European life insurers experienced some normalization in spreads and reduced reserve pressures as yields rose, but anticipated rate declines in 2025 stress tests could reintroduce reinvestment risks and increase liability values.^[66]

Regulatory and Economic Context

Basel Accords and Capital Requirements

The Basel III framework, developed by the Basel Committee on Banking Supervision (BCBS), addresses interest rate risk in the banking book (IRRBB) primarily under Pillar 2, emphasizing supervisory review and internal capital adequacy assessment processes (ICAAP) rather than prescribing specific minimum capital requirements.^[35] This approach integrates IRRBB into banks' overall risk management, requiring institutions to measure and manage the risk to both economic value of equity (EVE) and earnings arising from adverse interest rate movements.^[35] The standardized framework for IRRBB, finalized in April 2016, provides a consistent methodology for assessing exposures using six prescribed interest rate shock scenarios—parallel up and down, steepener and flattener, and short rates up and down—calibrated based on historical data from major currencies. In July 2024, the Basel Committee recalibrated the sizes of these shocks using updated historical data from December 2015 to December 2023, incorporating local currency-specific factors, a more conservative 99.9th percentile for shock determination, and finer rounding to 25 basis points, with implementation required by January 1, 2026.^[35]^[76] Banks categorize banking book positions into rate-sensitive instruments, slot cash flows into 19 maturity buckets, and compute changes in EVE (ΔEVE) and net interest income (NII) under these shocks, incorporating behavioral assumptions for items like non-maturity deposits (NMDs).^[35] For NMDs, the framework distinguishes core (stable) deposits, capped at 90% for retail transactional accounts and slotted into shorter maturities (up to five years), from non-core portions to reflect their partial long-term nature.^[35] Supervisory outlier tests serve as a key mechanism to identify banks with excessive IRRBB, with supervisors required to implement at least one test comparing the maximum ΔEVE across the six scenarios to 15% of the bank's Tier 1 capital.^[35] Additional tests may focus on earnings at risk (EaR), measuring NII impacts over a 12-month horizon against thresholds tied to the bank's earnings stability, ensuring comparability across institutions.^[35] Breaches trigger enhanced supervisory scrutiny, with a strong presumption for capital consequences if risk management is deemed inadequate.^[35] Post-2016 guidelines mandate implementation by January 2018, including public disclosures of IRRBB profiles starting from data as of December 31, 2017, for year-end reporters.^[35] Banks must incorporate stress testing into their ICAAP, applying the prescribed shocks alongside institution-specific severe scenarios to evaluate EVE and NII sensitivities, basis risk, and optionality.^[35] These tests promote robust governance and mitigation strategies, with periodic recalibration of shocks every five years to reflect market conditions.^[35] Criticisms of the framework highlight potential underestimation of IRRBB from NMD modeling, particularly in rising rate environments where deposit volatility increases but banks often retain long maturity assumptions without timely adjustments.^[77] Empirical analysis shows that only about 20% of NMDs are treated as short-term (zero maturity) under contractual rules, while others are assigned extended maturities, potentially overstating stability and exposing capital to unrecalibrated risks.^[77] This reliance on behavioral assumptions, constrained by standardized caps, may delay model updates and amplify vulnerabilities during monetary tightening.^[77]

Broader Economic Implications

Interest rate risk plays a pivotal role in the transmission of monetary policy, as changes in central bank policy rates directly influence borrowing costs for households and non-financial corporations (NFCs), thereby affecting consumption and investment decisions that shape aggregate demand. Higher policy rates typically raise interest payments on variable-rate debt, reducing disposable income for indebted households and cash flows for leveraged firms, which in turn curbs spending and economic activity through the cash-flow channel. Meanwhile, the interest rate channel operates via intertemporal substitution, where elevated rates encourage saving over current consumption, and the wealth channel, where asset price declines diminish household net worth and collateral availability for further borrowing. This transmission is heterogeneous: in regions like the euro area, where about 70% of household loans are fixed-rate, the pass-through to borrowing costs occurs more gradually compared to economies with higher variable-rate exposure.^[78]^[79] Systemic risks from interest rate fluctuations can amplify into broader contagion, as evidenced by historical episodes of rapid rate hikes. The 1994 bond market turbulence, triggered by unexpected Federal Reserve tightening, led to sharp bond price declines and widespread losses in fixed-income portfolios, heightening financial stress and contributing to a global sell-off that strained corporate borrowing and housing finance amid rising yields. More recently, the 2022 Federal Reserve rate hikes, which raised the federal funds rate from near zero to over 4%, significantly impaired housing market dynamics by increasing mortgage costs and locking in homeowners with low-rate loans, resulting in a 44% drop in borrower mobility and an 8% national rise in house prices due to reduced supply. For corporate debt, these hikes elevated servicing pressures on non-investment-grade firms with 35% floating-rate exposure, potentially increasing the share of at-risk debt (interest coverage ratio below 2) to 28% by late 2026, though aggregate resilience persisted due to high fixed-rate debt levels. Such events underscore how interest rate shocks can propagate through asset markets, exacerbating vulnerabilities in housing affordability and corporate leverage.^[32]^[80]^[81] On a global scale, interest rate risk manifests through carry trades, where investors borrow in low-yield currencies like the Japanese yen to fund investments in higher-yielding emerging market assets, exposing these economies to sudden U.S. rate shifts that reverse capital flows. Unwinding of yen-funded carry trades, estimated at $250 billion in 2024, amid U.S. policy uncertainty and Bank of Japan hikes, caused sharp depreciations in emerging market currencies such as the Mexican peso and Brazilian real, amplifying volatility and debt burdens for dollar-denominated borrowers. Emerging markets remain particularly vulnerable, as narrowing U.S. interest rate differentials since 2022 have triggered capital outflows, elevating exchange rate risks and hedging costs for firms with foreign currency exposure.^[82]^[83] The Federal Reserve's rate hikes from 2022 to 2023, aimed at curbing persistent inflation, intensified tradeoffs between price stability and financial risks, with tighter conditions straining corporate refinancing and household debt service amid elevated uncertainty. Subsequent rate cuts starting in September 2024 and continuing through 2025 have aimed to support growth while monitoring inflation, potentially alleviating some refinancing and debt service pressures. These hikes contributed to rising medium-term inflation expectations and a potential global growth downturn, with models estimating a 5% chance of growth falling below 0.4% in the coming year, driven by asset price corrections and leveraged vulnerabilities. In emerging markets, the stronger U.S. dollar from sustained high rates has worsened external debt pressures, highlighting the need for coordinated policy to mitigate spillover effects.^[83]^[84]^[85]

References

[1]
Interest Rate Risk | FDIC.gov
Aug 11, 2025 · Interest rate risk is the exposure of a bank's current or future earnings and capital to adverse changes in market rates.
[2]
[PDF] Interest Rate Risk | Comptroller's Handbook | OCC.gov
IRR results from differences between the timing of rate changes and the timing of cash flows (repricing risk); from changing rate relationships among different ...
[3]
Basel Framework
### Summary of Interest Rate Risk in the Banking Book (IRRBB)
[4]
Interest Rate Risk: Definition and Impact on Bond Prices - Investopedia
Interest rate risk is the potential for a bond or other fixed-income asset to decline in value when interest rates move in an unfavorable direction.What Is Interest Rate Risk? · Understanding Interest Rate Risk · Example
[5]
Interest Rate Risk - Definition, How to Mitigate the Risk
Interest rate risk is the probability of a decline in the value of an asset resulting from unexpected fluctuations in interest rates.
[6]
Garn-St Germain Depository Institutions Act of 1982
During the 1970s, the US economy was plagued by high inflation. At the time banks and thrift institutions were restricted from raising their deposit interest ...
[7]
[PDF] A Short History of Financial Deregulation in the United States
This paper outlines the major regulatory changes over the last three decades that created the context in which the crisis occurred. Background. Interest rate ...
[8]
Chapter 13 Deregulation of Banking: A Worldwide Phenomenon in
Experience during the inflationary period of the 1970s also indicated that interest rate controls did little to stabilize funding to the housing market and ...
[9]
The Fed - Why do interest rates matter? - Federal Reserve Board
Jul 19, 2024 · Interest rates influence borrowing costs and spending decisions of households and businesses. Lower interest rates, for example, often encourage more people to ...
[10]
[PDF] Present Value Basics - NYU Stern
Effective Interest rate = exp06-1 = 6.18% The future value of $ 50,000 at the end of 10 years with continuous compounding would then be: Future Value of $ 50, ...
[11]
Understanding Interest Rate Risk in Long vs. Short-Term Bonds
Interest rate risk occurs when interest rates change, affecting the value of fixed-income securities. Because bond prices move opposite to rates, a rate ...
[12]
Floating-Rate Notes: 4 Key Considerations - Charles Schwab
Mar 20, 2025 · Investment-grade floating-rate notes prices tend to be more stable than their fixed-rate counterparts, so they may be worth considering ...Missing: instruments | Show results with:instruments
[13]
[PDF] When Interest rates Go up, Prices of Fixed-rate Bonds Fall - SEC.gov
A fundamental principle of bond investing is that market interest rates and bond prices generally move in opposite directions. When market interest rates rise, ...
[14]
Inverse Relation Between Interest Rates and Bond Prices
Bond prices typically rise when interest rates drop. Rates can drop because of market forces or because of policy decisions, such as the Federal Reserve ...
[15]
Bond Valuation: Calculation and Example - Investopedia
The theoretical fair value of a bond is calculated by discounting the future value of its coupon payments by an appropriate discount rate.
[16]
Convexity in Bonds: Definition and Examples - Investopedia
Convexity refers to how much the shape of the curve changes on a graph showing the link between a bond's price and its yield.
[17]
The One-Minute Guide to Zero Coupon Bonds | FINRA.org
Oct 20, 2022 · Long-term zeros can be particularly sensitive to changes in interest rates, exposing them to what is known as duration risk. Also, zeros may not ...
[18]
Recession of 1981-82 | Federal Reserve History
Despite this, long-run interest rates continued to rise. The ten-year Treasury bond rate increased from about 11 percent in October 1980 to more than 15 percent ...
[19]
CREDIT MARKETS; 30-YEAR U.S. BONDS HIT 15%
Sep 9, 1981 · The 15 percent yield on 30-year Treasury bonds was achieved when the issue traded at 92 18/32, not much below the closing price of about 92 26/ ...
[20]
[PDF] Principles for the Management of Interest Rate Risk
Interest rate risk policies should also identify quantitative parameters that define the level of interest rate risk acceptable for the bank. Where ...
[21]
[PDF] Section 7.1 Sensitivity to Market Risk - FDIC
Repricing risk reflects the possibility that assets and liabilities will reprice at different times or amounts and negatively affect an institution's earnings, ...
[22]
[PDF] Interest Rate Risk - OCC.gov
Interest rate risk is the risk to earnings or capital arising from movement of interest rates, from differences in timing of rate changes and cash flows.
[23]
Gap Analysis - Examiner's Guide
Dec 6, 2024 · Gap analysis is a simplistic IRR measurement model used by small or non-complex institutions that provides an easy way to identify repricing gaps.
[24]
Nowhere to Go but Up: Managing Interest Rate Risk in a Low ... - FDIC
This article describes the current interest rate environment and its relevance for the banking industry's IRR profile.
[25]
Types of Interest Rate Risk - Examiner's Guide
Dec 6, 2024 · Types of IRR include: Repricing Risk, Repricing risk arises from the possibility that a credit union's assets and liabilities will reprice at different times ...
[26]
[PDF] Risk Management Lessons from the Global Banking Crisis of 2008
Oct 21, 2009 · First, the group conducted interviews with thirteen firms at the end of 2008 to review specific funding and liquidity risk management challenges.
[27]
[PDF] Interest Rate Risk and Bank Equity Valuations
May 1, 2012 · We construct a new measure of the mismatch between the repricing time or maturity of bank assets and liabilities and analyze how the reaction of ...
[28]
Yield Curve Strategies | CFA Institute
Convexity is a second-order effect describing a bond's price behavior for larger rate movements and is affected by cash flow dispersion. A barbell portfolio ...
[29]
Chapter 3 Sovereign Bonds: What Does the Yield Curve Tell Us? in
Meanwhile, a flat or humped yield curve is generally associated with an uncertain economic outlook. Specifically, an inverted yield curve has historically ...
[30]
Interest Rate Risk Management - Pace University Webspace
In addition to flattening and steepening, yield curves can also become less humped (positive butterfly change) or more humped (negative butterfly change).
[31]
[PDF] The anatomy of the bond market turbulence of 1994, December 1995
This paper examines the sharp rise in bond yield volatility across the major bond markets in 1994. The analysis covers thirteen industrialised countries and is ...
[32]
[PDF] Cashflow Duration and Immunization (Part I) - MATH 372 Financial ...
The Macaulay duration denoted Dmac of an investment is the weighted average time at which the investment's payments will occur. The weights are the present ...
[33]
WWWFinance - Duration Measures: Historical Perspective
Oct 30, 1995 · In 1938, Frederick Macaulay suggested a method for determining price volatility of bonds. He gave the name duration to the measure, but it is now often called ...
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[PDF] Part A Page 1 Chapter 11: Duration, Convexity and Immunization ...
Macaulay duration or simply just duration (MacD), an even better index, is a weighted average of various times of payments with the present value of each cash ...
[35]
Fixed Income Analysis Documentation - V-Lab
When the curve twists (short rates rising while long rates fall) or steepens/flattens, the standard duration-convexity formula can produce significant errors ...
[36]
[PDF] CHAPTER 16: MANAGING BOND PORTFOLIOS
... small, parallel shift in yields. Duration is a first (linear) approximation only for small changes in yield. For larger changes in yield, the convexity ...Missing: limitations | Show results with:limitations
[37]
Bond Strategies, Duration, Modified Duration, Convexity, etc
Similarly, the 5 year 5% coupon bond has a modified duration of 4.41, while the 10 year 5% coupon bond has a modified duration of 7.92. In both cases, the ...<|control11|><|separator|>
[38]
[PDF] Convexity - NYU Stern
Convexity is related to the curvature, i.e. the second derivative of the price function. • Using convexity together with duration gives a better approximation ...
[39]
[PDF] Relative Impact of Duration and Convexity on Bond Price Changes
As shown in Appendix A. the second derivative (convexity) can be written as equation (5). v= 2P.
[40]
Convexity & Convexity Adjustment | CFA Level 1 - AnalystPrep
Sep 22, 2023 · Convexity measures the non-linear, second-order effect of yield changes on a bond's price. It captures the curvature of the price-yield relationship.
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Understanding Bond Convexity - Breckinridge Capital Advisors
Feb 11, 2025 · The curved line illustrates a bond's convexity. which can be thought of as a second derivative of the relationship between a bond's price and ...
[42]
Key Rate Durations - Semantic Scholar
Sep 30, 1992 · THOMAS S.Y. HO is the President of Global Advanced Technology Corporation in New York. here are a wide variety of interest rate-contingent ...
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Ho, T.S.Y. (1992) Key Rate Durations Measures of Interest Rate ...
ABSTRACT: We propose a valuation for the bond in which an issuer and a holder are simultaneously granted the right to exercise a call and put options. As the ...
[44]
[PDF] Risk Management: The Total Return Approach and Beyond - SOA
Nov 17, 2004 · Ho, Thomas (1992) “ Key rate durations: meas- ure of interest rate risk” Journal of Fixed Income, volume 2 number 2 September 1992. Ho, Thomas ...
[45]
[PDF] Mortgages and MBS - NYU Stern
Mortgage-Backed Securities 13. The Negative Convexity of MBS. Securities backed by fixed-rate mortgages have "negative convexity." This refers to the fact ...
[46]
Negative Convexity: Definition, Example, Simplified Formula
Negative convexity occurs when the shape of a bond's yield curve is concave. Most mortgage bonds are negatively convex, and callable bonds usually exhibit ...
[47]
[PDF] Do Banks Hedge Using Interest Rate Swaps? - NYU Stern
Jun 1, 2024 · Banks can use swaps to hedge the interest rate risk of individual assets, a portfolio of loans or securities, or their entire balance sheet.
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[PDF] Debt Maturity and the Use of Interest Rate Derivatives by ...
Using this approach, we find strong evidence that firms employ interest rate swaps to hedge interest rate risk arising from their short-term debt obligations.
[49]
[PDF] Eurodollar Futures, and Forwards - faculty.weatherhead.case.edu
We now illustrate how ED futures can be used to hedge against unantici- pated interest rate movements. Hedging Against Interest Rate Increases. Consider, the ...
[50]
[PDF] Interest Rate Risk Management - FHFA
Interest rate risk is the vulnerability of current or future earnings and capital to interest rate changes, affecting income, expenses, and cash flows.
[51]
[PDF] Understanding Treasury Futures
Understanding Treasury Futures. 15. Portfolio Hedging ... Treasury futures contract which most closely conforms to the duration of the portfolio constituents .
[52]
[PDF] Defining Asset-Liability Management - SOA
Thus, the strategy of immunization of surplus ratio calls for setting the duration of assets equal to the duration of liabilities. This is the most common ap- ...
[53]
Banking on interest rates: A playbook for the new era of volatility
Jun 4, 2024 · Interest rate scenarios. Banks can employ Monte Carlo simulations and other models to analyze a range of scenarios, including extreme and ...
[54]
Frequently asked questions: Liability-driven investing (LDI ... - Milliman
Feb 20, 2025 · One of the primary reasons for adopting an LDI strategy is to reduce interest rate volatility risk. The assets invested in the LDI strategy ...Missing: rebalancing | Show results with:rebalancing
[55]
[PDF] Interest rate risk in the banking book
This document is about interest rate risk in the banking book, published in April 2016, and available on the BIS website.
[56]
[PDF] Interest-Rate Risk Management Section 3010.1
Interest-rate risk (IRR) is the exposure of an institution's financial condition to adverse movements in interest rates. Effective management is essential.
[57]
[PDF] Interest Rate Risk Statistics Report - OCC.gov
Earnings at risk (EAR): EAR models, also referred to as earnings simulation models, use data on the bank's current financial position combined with managerial ...
[58]
https://www.soa.org/globalassets/assets/library/monographs/finance/asset-liability-integration/2002/january/m-fi02-1-02.pdf
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Going negative: the ECB's experience - European Union
Aug 26, 2020 · Interest rate margins, however, are only one part of banks' profitability. ... impact of negative rates on banks' profitability is much broader.Missing: post- | Show results with:post-
[60]
[PDF] Negative interest rates in the euro area: Does it hurt banks? (EN)
The econometric results confirm the effect of the interest rate level on bank profitability and, in some specifications, also suggest an additional negative ...
[61]
A Look Back At The Negative Interest Rate Era | Weekly Economic ...
Mar 29, 2024 · Negative rates damaged the earnings of European banks: the direct cost of holding liquidity rose significantly to €15 billion a year.Missing: impact | Show results with:impact
[62]
Interest Rates & Insurance - NAIC
Aug 24, 2023 · Prolonged periods of low interest rates negatively affect the financial performance of life insurance firms in multiple ways. In late 2021, ...
[63]
How Much Risk Do Variable Annuity Guarantees Pose to Life ...
This article explores the different types of variable annuity guarantees, the extent of the risk they pose to insurers, and the practices used by insurers to ...
[64]
Managing Convexity Risk as Interest Rates Rise - SOA
Convexity risk associated with dynamic lapse behavior can be mitigated with derivatives. For example, interest rate caps and payer swaptions can be ...
[65]
Life insurance convexity - ScienceDirect.com
Life insurance convexity is when surrender options cause the duration of contracts to decline as interest rates rise, due to policyholders having stronger ...
[66]
Shifting landscapes: life insurance and financial stability
Sep 16, 2024 · Low-for-long interest rates have squeezed life insurers' profit margins and increased their exposure to riskier assets, raising financial ...
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[PDF] The transformation of the life insurance industry: systemic risks and ...
In particular, the sharp rise in interest rates in 2022 triggered significant mark-to-market losses on insurers' interest rate swap and futures positions, ...
[68]
[PDF] Banking on assumptions? How banks model deposit maturities
Our analysis shows that only 20% of NMDs are effectively treated as floating-rate liabilities with zero maturity, while a non-negligible portion is assigned ...Missing: criticism | Show results with:criticism
[69]
Interest rate risk exposures of non-financial corporates and ...
Nov 15, 2024 · The exposure of non-financial corporates (NFCs) and households to interest rate risk directly affects the transmission of monetary policy to aggregate demand.
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[PDF] Philip R Lane: The transmission of monetary policy
Oct 11, 2022 · Interest rate and cash-flow channels. Interest rate changes affect households and firms through several channels. First, via the.<|separator|>
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[PDF] Locked In: Mobility, Market Tightness, and House Prices
Specifically, the 2022 rate hikes occurred during a period of already-tight local housing markets, due to demographic trends and other factors (Anenberg and ...
[72]
Stress Testing the Corporate Debt Servicing Capacity: A Scenario ...
May 9, 2024 · Both short- and long-term interest rates rose steeply since early 2022, raising concerns about the nonfinancial corporate sector's debt- ...Missing: hikes | Show results with:hikes
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[PDF] The market turbulence and carry trade unwind of August 2024
Aug 27, 2024 · Financial market volatility resurfaced in early August as the unwinding of leveraged trades in equity and currency markets amplified the initial ...
[74]
[PDF] Global Financial Stability Report, April 2025; Chapter 1
Apr 22, 2025 · Risk-adjusted returns on emerging market carry trades are vulnerable to higher inflation uncertainty. The chance of capital outflows from ...
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[PDF] WORLD ECONOMIC OUTLOOK UPDATE
Jan 24, 2025 · Higher-for-even-longer interest rates could worsen fiscal, financial, and external risks. A stronger US dollar, arising from interest rate ...