Either Explain briefly various types of interest rate risk faced by companies/ banks.

Various types of Interest rate risk faced by companies/ banks are as follows: (1) Gap Exposure: A gap or mismatch risk arises from holding assets and liabilities and off-balance sheet items with different principal amounts, maturity dates or re-pricing dates, thereby creating exposure to unexpected changes in the level of market interest rates. This exposure is more important in relation to banking business. (2) Basis Risk: Market interest rates of various instruments seldom change by the same degree during a given period of time. The risk that the interest rate of different assets, liabilities and off-balance sheet items may change in different magnitude is termed as basis risk. For example, while assets may be benchmarked to Fixed Rate of Interest, liabilities may be benchmarked to floating rate of interest. The degree of basis risk is fairly high in respect of banks that create composite assets out of composite liabilities. (3) Embedded Option Risk: Significant changes in market interest rates create another source of risk to banks' profitability by encouraging prepayment of cash credit/demand loans/term loans and exercise of call/put options on bonds/debentures and/or premature withdrawal of term deposits before their stated maturities. (4) Yield Curve Risk: The movements in yield curve are rather frequent when the economy moves through business cycles. Thus, banks should evaluate the movement in yield curves and its impact on the portfolio values and income. (5) Price Risk: Price risk occurs when assets are sold before their stated maturities. In the financial market, bond prices and yields are inversely related. The price risk is closely associated with the trading book, which is created for making profit out of short-term movements in interest rates. Banks which have an active trading book should, therefore, formulate policies to limit the portfolio size, holding period, duration, defeasance period, stop loss limits, marking to market, etc. (6) Reinvestment Risk: Uncertainty with regard to interest rate at which the future cash flows could be reinvested is called reinvestment risk. Any mismatches in cash flows would expose the banks to variations in NII as the market interest rates move in different directions.