- Present credits and debts;
- Future credits and debts; and
- Conditional credits and debts.
An interest rate position either on the asset side or on the liability side is subjected to
fluctuations of rates. An enterprise, a bank or an investor is said to have a “long
position” in the case of increase in the rate of interest. Conversely, these operators are
said to have a “short position” in the event of decrease in the interest rate.
When an enterprise is faced with a situation of interest rate risk, it can:
- Either decide to do nothing and keep its position uncovered;
- Or cover itself by taking recourse to organized markets of interest rate options and
futures; - Or cover itself on over-the-counter (OTC) markets, future rate agreements,
forward-forward agreements interest rate options, caps, floors, swaps, etc.
There is a close nexus between IRR and prices of financial securities. Therefore it would
be useful to know, how the prices of financial securities vary. The price of a financial
security is equal to the present value of cash inflows that it generates during its life. In
general, the price of a fixed rate financial security refundable at the end of the borrowing
period depends upon:
- The coupon amount. Coupon is equal to the product of nominal value of a bond
and interest rate; - The mode of capital refund. Normally, refund is done in one lot at the end of the
life of a bond, but it can be done in installments over a period of a number of
years; - Market interest rate;
- Maturity period of the borrowing.
When market interest rate increases, the price of the fixed-income security decreases and
conversely when market interest rate decreases, the price of the fixed-income security
increases.
- Balance Sheet Risk (or Capital Risk)
Balance sheet risk is the consequence of an interest variation, which diminishes the value
of certain assets or increases the value of debts. For example, if an Indian company has
brought American fixed-rate treasury bonds and if the bond coupon rate in America
increases, in that case the value of American bonds in the balance sheet will decrease.
When market interest rate (or yield) increases, there is an arbitrage operation which
lowers the prices of bonds until their yield becomes equal to the prevailing rate in the
market. If the investor is then constrained to liquidate his bonds, he suffers a capital loss.