A Financial Econometric Analysis of the Determinants of Interest Rate Risk in the US

Abstract

1. Introduction Capital in a market-oriented economy is allocated through the price system. The interest rate is the price of capital paid to borrow debt capital. The factors that affect supply of and demand for capital (funds) determine the cost of capital, too. The risk of capital losses to which suppliers and demanders of capital are exposed because of unanticipated changes of interest rates is called as the interest rate risk (Thalassinos et al., 2010). This risk is measured by a component, added on the base rate (the real risk-free rate of interest), which is called the risk premium. The risk increases the risk premia on interest rates and it is reallocated among people in our economy, from the riskiest to the less risky ones. All agents of an economy, suppliers or demanders of funds, are exposed to interest rate risk. Everyone is sensitive to interest rate movements and this volatility has increased significantly. Since it is difficult to predict the direction and magnitude of interest rate changes, borrowers and lenders (especially shorter-maturity and variable-rate debts) face an interest rate exposure. There is a type of interest rate risk that affects every participant in the financial markets, the basis risk, which is the mismatching of interest rate bases for associated assets and liabilities. A second type of risk is the gap risk (more typical of a nonfinancial firm) which arises from mismatched timing in repricing interest-rate-sensitive assets and liabilities. For financial institutions, portfolio managers, and investment on securities, there are also a price risk and a reinvestment risk. Another risk is due to the average expected inflation rate over the life of a loan. Inflation erodes the purchasing power of the dollar and causes capital losses (lowers the real rate of return). In addition, there is a risk that the borrower could default on a loan. Besides, a liquidity risk exists because the financial assets cannot be converted to cash quickly and at a fair market value. Moreover, a maturity risk occurs due to high price sensitivity of long-term securities whenever interest rates rise. On the other hand, the reinvestment risk is the risk that affects more the short-term securities because a decline in interest rates will lead to lower income when financial instrument matures and funds are reinvested. Further, a foreign exchange risk (unexpected changes in exchange rates) can cause capital losses by altering the home currency value of foreign currency receipts or payments (Thalassinos, 2007). Likewise, a political risk may exist due to the possibility that political events in a particular country will cause some capital losses from expecting capital outflows from that country. Given the interest rate risks, every participant in the financial market requires a compensation for undertaking these risks. This remuneration is called the interest rate risk premium. We are interested to determine the factors that affect the different components of risk premier. The intelligent supplier or demander of capital must have knowledge of these factors affecting risk premium (and then interest rate) and be able to anticipate possible future changes in those factors. We are defining as risk premium the difference between a market rate of interest and the real risk-free rate of interest. [IRRP.sub.t] [congruent to] [RP.sub.t] = [i.sub.t] - [r.sub.t.sup.*] (1) where, IRRPt = interest rate risk premium, RPt = risk premium, it = a nominal market rate of interest and [rt.sup.*] = the real risk-free rate of interest (3-month T-bill rate minus the expected inflation rate). Consequently, risk premia are the prices of risk (components of the rate of return) built in financial assets priced (return) against the uncertainties related to the relevant state variables in our inherited risky economic system. As the uncertainties of the state variables (expected macro- variables) change over time, the risk related to the state macro-variables and hence the risk premia on interest rates vary over time. …