Abstract

Interest Rate Variation Risk Potential – a Concept for Managing the Interest Rate Variation Risk of Interest Rate-linked Financial Instruments

The experience of recent years has taught us that the instruments hitherto available for managing interest variation risks – interest variation balance sheets, elasticity concepts, duration hedging concepts – are no longer appropriate for measuring adequately the interest exposure associated with new interest rate-linked financial instruments such as interest rate swaps, interest rate futures and interest rate options. For, interest rate options are characterized by two factors requiring fundamental rethinking about the methods for measuring the interest rate variation risk: The yield on interest rate options is asymmetrically distributed, and the price of interest rate options is determined only in part by the yield curve. Based on a presentation of the shortcomings of traditional measurement methods, the present contribution introduces a new ratio-based concept, i.e. the interest rate variation risk potential, which takes account also of modern interest rate-linked financial instruments and allows reliable forecasting of the interest exposure attaching to portfolios put together at discretion. This concept allows the potential loss in value of port£folios to be described, i.e. a potential loss which is not likely to be surpassed with a specified probability factor being assumed for a specified period. The resultant ratio is calculated on the basis of the chance-constrained programming concept and stochastic simulation runs. This new ratio offers visible advantages over the present risk management instruments: It takes account of non-parallel changes in the yield curve as well as of interrelationships between behavioural characteristics of the interest rate-linked instruments and possible interest developments. At the same time, it allows a consolidated assessment of the totality of the individual risks involved, independently of the number of interest rate-linked financial instruments of a portfolio. This permits also the residual risks that have dodged duration hedging hitherto to be estimated in quantitative terms. This contribution ends on an outlook on the large variety of applications of the above described ratio (optimization of portfolios, use as controlling instrument) as well as on other unsettled issues.