MORNBFI Vol. 1 - Planters Development Bank

APP. Q-4308.12.31of this Appendix is interest rate risk andFX risk. Nevertheless, the principles setforth in the market risk managementprocess and sound risk managementpractices are generally applicable to allsources of market risk.a. Interest rate riskInterest rate risk is the risk that changesin market interest rates will reduce currentor future earnings and/or the economicvalue of a FI. Accepting interest rate risk isa normal part of financial intermediationand is a major source of profitability andshareholder value. Excessive orinadequately understood and controlledinterest rate risk, however, can pose asignificant threat to an FI’s earnings andcapital. Thus, an effective riskmanagement process that maintains interestrate risk within prudent levels is essentialto the safety and soundness of FIs.1. Sources of interest rate riska. Re-pricing riskThis is the most common type of interestrate risk and arises from differences in thematurity (for fixed-rate instruments) and repricing(for floating-rate instruments) of anFI’s assets, liabilities and off-balance sheetpositions. While such re-pricingmismatches are fundamental to the businessof financial intermediation, they also exposean FI’s earnings and underlying economicvalue to changes based on fluctuations inmarket interest rates.b. Basis riskBasis risk arises from imperfectcorrelations among the various interest ratesearned and paid on financial instruments withotherwise similar re-pricing characteristics. Ashift in the relationship between these ratesor interest rates in different markets can giverise to unexpected changes in the cash flowsand earnings spread between assets, liabilitiesand off-balance sheet instruments of similarmaturities or re-pricing frequencies.c. Yield curve riskYield curve risk is the risk that rates ofdifferent maturities may change by adifferent magnitude. It arises from variationsin the movement of interest rates across thematurity spectrum of the same index ormarket. Yield curves can steepen, flatten oreven invert. Unanticipated shifts of the yieldcurve may have adverse effects on an FI’searnings or underlying economic value.d. Option riskOption risk is the risk that the paymentpatterns of assets and liabilities will changewhen interest rates change. Formally, anoption gives the option holder the right, butnot the obligation to buy, sell, or in somemanner alter the cash flow of an instrumentor financial contract. Options may be standaloneinstruments or may be embeddedwithin otherwise standard instruments.Examples of instruments with embeddedoptions include various types of bonds,notes, loans or even deposits which give acounter-party the right to prepay or evenextend the maturity of an instrument or tochange the rate paid. In some cases, theholder of an option can force a counterpartyto pay additional notional, or to forfeitnotional already paid.The option holder’s ability to choose toalter cash flows creates an asymmetricperformance pattern. If not adequatelymanaged, the asymmetrical pay-offcharacteristics of instruments withoptionality can pose significant riskparticularly to those who sell the options,since the options held, both explicit andembedded, are generally exercised to theadvantage of the holder and thedisadvantage of the seller.2. Measuring the effects of interest rate riskChanges in interest rates affect bothearnings and the economic value of an FI.This has given rise to two separate, butcomplementary, perspectives for evaluatingan FI’s exposure to interest rate risk.Manual of Regulations for Non-Bank Financial InstitutionsQ RegulationsAppendix Q-43 - Page 3