With repeated cuts in interest rates, banks are facing a challenge. Though a volatile interest rate is undesirable, banks can use the hedging instruments to reduce the risk.If cash is the life-blood of any organization, the interest rate it pays for the cash is the blood pressure. Volatile interest rates, like volatile blood pressure, are harmful but unavoidable. They need to be managed and appropriate risk tools and hedge mechanisms are a necessity in the current environment.

Let us look at interest rate volatility and its impact on a financial institution. The impact may be caused from the asset side or the liability side. Interest rate risk is generally defined as the adverse impact of interest rate movements on an institution's Net Interest Income (NII) and market value. This is dependent on the maturity profile of the assets and liabilities of the institution as well as their reprising terms. The changes in the value of the assets and liabilities may be favorable or adverse. Decline in asset value or increase in liability value is adverse whereas increase in asset value and decrease in the liability value is favorable. The market value of a tradable asset is easily obtained and the portfolio can be marked to market. Though the loans are usually carried at book values it is necessary to compute the market values through alternative interest scenarios. This is known as impact on the Economic Value of Portfolio Equity (EVPE). Historically, for banks and institutions, the liability costs are fixed. A reduction in interest rate does not immediately reduce the cost of its liabilities, whereas the assets get repriced immediately. For a corporate, the change in interest rate environment creates mismatches in its cost structure.

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