Interest rate risk

by Forex-Library

The Role of Interest Rates

Customers, investors and buyers are vulnerable to have a huge impact on their financial status since their businesses and economy conditions are unavoidably affected by interest rates. More specifically, the changes in interest rates affect the costumer’s purchasing power, the company’s cash flow on a daily basis, and the bank’s loan and credit activity spearheading, in such a way, the global market. The next few paragraphs will give you an idea on the matter of interest rates on the global market.

How does it work?

The interest rate is the amount of money that a lender charges to a borrower for the asset's use, to put it simple, interest rates are related to the amount of cash that is in circulation. No matter where the interest rate comes from: a corporation or another depository organization or banks (institutional level), from customers acquiring goods and services like their homes and cars (retail level), the truth is, they all become part of the global market place and it can be eventually considered as the soul of the market.

The central bank is the essential foundation of the economic system, as it controls lends funds which are, in many cases, holding another depository institution or the government overnight. This lending and borrowing activity produces liquid interest rates that are intended to produce economic growth and safety.

The monetary policy and the market force as such, both play an important role within the economic activity worldwide: monetary policies, generally dictated by the central bank, are in charge of stabilizing prices and reducing unemployment rates by accomplishing the most accurate measures and producing the most liquid interest rates. If there is more purchasing demand out there (respective to the amount of cash in circulation), the amount of money or interest rate will be more worthy.

What About The Change in Rates?

Whenever interest rates vary, the lending level between all the banks and other entities may vary as well. Now, in order to determine the difference in the bond's yield (DV01), one has to calculate the interest rate risk which represents 001% in a 1000 basis points. The result would ultimately be marked as a change in interest rate.

The important thing to understand here is that this sort of “economic behavior” is ultimately determined by the banks when they borrow and lend money to each other (or other entities like companies and individuals). The perfect formula for banks to decrease interest rates is when there is a sensation of slow growth and stable prices. On the other hand, they will increase interest rates when the formula combines a sensation strong growth and rocketing prices. This is how this interchangeably operation will affect the soul of the interest rates at the market.
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