Interest rate risk is the risk that arises for bond owners from fluctuating interest rates. How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes in the market. The sensitivity depends on two things, the bond’s time to maturity, and the coupon rate of the bond.
Interest rate risk analysis is almost always based on simulating movements in one or more yield curves using the Heath-Jarrow-Morton framework to ensure that the yield curve movements are both consistent with current market yield curves and such that no riskless arbitrage is possible.
There are a number of standard calculations for measuring the impact of changing interest rates on a portfolio consisting of various assets and liabilities. The most common techniques include:
- Marking to market, calculating the net market value of the assets and liabilities, sometimes called the “market value of portfolio equity”
- Stress testing this market value by shifting the yield curve in a specific way.
- Calculating the value at risk of the portfolio
- Calculating the multiperiod cash flow or financial accrual income and expense for N periods forward in a deterministic set of future yield curves
- Doing step 4 with random yield curve movements and measuring the probability distribution of cash flows and financial accrual income over time.
- Measuring the mismatch of the interest sensitivity gap of assets and liabilities, by classifying each asset and liability by the timing of interest rate reset or maturity, whichever comes first.
- Analyzing Duration, Convexity, DV01 and Key Rate Duration.