Which of the following are accurate statements about interest rate risk? Check all that apply. It arises when the banking system was heavily regulated. It arises because the value of an asset changes when interest rates change. Lately, it has increased due to the growing volatility of interest rates. Changes in interest rates affect only bank liabilities and have no effect on assets.
The Correct Answer and Explanation is:
The accurate statements about interest rate risk are:
- It arises because the value of an asset changes when interest rates change.
- Lately, it has increased due to the growing volatility of interest rates.
Explanation:
Interest Rate Risk (IRR) refers to the risk that the value of an asset or liability will change due to fluctuations in interest rates. It is a critical concern for financial institutions, investors, and anyone dealing with fixed-income assets like bonds or loans.
- It arises because the value of an asset changes when interest rates change.
- This statement is true because the value of financial assets (such as bonds, loans, or mortgages) is inversely related to changes in interest rates. When interest rates increase, the present value of fixed-income assets decreases, and when interest rates decrease, the value of these assets increases. This relationship is a core component of interest rate risk.
- Lately, it has increased due to the growing volatility of interest rates.
- This is also accurate. Interest rate risk has become more pronounced recently due to the growing volatility in global interest rates, largely due to factors such as inflation concerns, economic recovery post-pandemic, and central banks adjusting their policies. These factors make interest rate movements more unpredictable, leading to higher risk for financial institutions and investors.
- It arises when the banking system was heavily regulated.
- This statement is inaccurate. While interest rate risk can exist in any banking system, it is not specifically tied to the level of regulation. In fact, regulatory measures often aim to manage such risks (e.g., through capital requirements or stress tests), so heavy regulation doesn’t directly lead to more interest rate risk.
- Changes in interest rates affect only bank liabilities and have no effect on assets.
- This is false. Interest rate changes affect both bank liabilities and assets. For example, a bank’s loan portfolio (asset) can be sensitive to interest rate changes, as can its borrowing costs (liabilities). Thus, both sides of the balance sheet are impacted by interest rate fluctuations.
In conclusion, interest rate risk is primarily concerned with how changes in rates affect the value of assets and liabilities, and its importance has grown due to increasing rate volatility.
