Overview

Interest Rate risk is the risk that the value of an asset changes due to a change in the market interest rates. Interest rate risk can impact multiple types of financial securities, including fixed income, equity and derivative.

Approaches to Interest Rate Risk

The topic of fixed income risk is vast. There are multiple approaches to computing and managing it. For the purposes of this corner, we categorize approaches into the following groups.

• Statistical: a statistical approach to fixed income risk views the value of the portfolio in the future as being a random variable and subject to standard statistical analysis.
  
  Statistical models include
  
  
  • Term Structure Models
  • Short Rate Models
• Sensitivity Based: seeks to establish the relationship between the value of a fixed income and certain exogenous variables, such as the interest rate. (see sensitivity analysis) This type of analysis would let you know how much you stand to profit or lose from a certain hypothesized change in the underlying variable.
  
  While not inherently statistical, it can be married with the statistical approach by specifying a statistical distribution for underlying variables.
  
  Sensitivity based measures include:
  
  
  • Duration
  • Convexity