Lecture16 - 11/1/2010 MGMT 4370 / MGMT 7760 Risk Management...

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11/1/2010 1 MGMT 4370 / MGMT 7760 Risk Management Aparna Gupta Lally School of Management and Technology Office: PITTS 2104 Email: [email protected] Phone: x2757 Interest Rate Risk Interest rates affect almost all financial activities, not to mention Wall Street responding promptly: Interest Rates: The Zero Percent Solution Bloomberg Business Week; COMMENTARY August 25, 2010, 11:01PM EST There are smart arguments for the world's central banks, particularly the Fed, to start raising rates. They just aren't smart right now, says Mark Gilbert. . ... Keeping rates too low for too long damages the recovery by "raising asset prices and incentivizing investment in riskier asset " according to Rajan which and incentivizing investment in riskier assets , according to Rajan, which threatens to create yet more bubbles that central banks are unwilling to tackle. Moreover, savers aren't simply punished by near-zero returns; their nest eggs shrink further when the inflation rate outpaces deposit rates. And if improving consumer confidence is a prerequisite for a rebound in growth, then near-zero interest rates send the wrong message: They destroy nascent hope in the economic outlook and make the future that much more uncertain for consumers and companies. Interest-rates affect values of assets and liabilities of most corporations, for example, pension funds, banks, other financial intermediaries. 2 Aparna Gupta, Lally School, RPI Relevance of Interest Rate Risk We have seen mortgages (types of retail credit which employ interest rates), mortgage-related assets – Mortgage-backed Securities. Fixed-interest government bonds – which fall in value when interest rates rise. Corporate bonds fall in value when interest rates rise due to corporate bonds getting downgraded in ratings. Opposite to default, sometimes borrowers can also exercise the option to prepay mortgage when interest rates decline – thus cutting on the total interest earned on the loans. First goal is to look at fixed-income instruments and develop a basic understanding of interest rate risk. Second goal is to look at key derivative instruments used to manage interest-rate risk. This will prepare us better to explore the topic of credit risk valuation and management. Also allow us to study risks in asset-liability management. 3 Aparna Gupta, Lally School, RPI Types of Interest Rate Risk Value of a fixed-income security (held by an institution) changes due to change in market interest rates. – As a result the firm suffers an economic loss, especially if this is an
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This note was uploaded on 01/27/2011 for the course MGMT 4370 taught by Professor Gupta during the Fall '10 term at Rensselaer Polytechnic Institute.

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Lecture16 - 11/1/2010 MGMT 4370 / MGMT 7760 Risk Management...

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