Fundamentals of interest rate risk and the banking book

Paul Newson

For any study of IRRBB, it is logical to begin by defining and explaining separately both embedded terms: interest rate risk and the banking book. In this chapter interest rate risk will be introduced, first as a particular category of market risk, followed by a description of the various forms it can take, namely yield curve risk, basis risk and option risk. The chapter concludes with an attempt to define the banking book although, as will become apparent, this is not necessarily as straightforward as it might initially appear.

MARKET RISK AND ITS DIFFERENT FORMS

From the standpoint of a bank, market risk is the risk that changes in market prices may negatively impact its financial well-being. The vague term “financial well-being” is chosen deliberately at this stage to avoid clouding the issue by discussing in detail, and too early, the differing accounting treatments employed in banking and trading books.

The term “market price” may be defined as a wholesale price that is quoted in a liquid, two-way market comprising willing buyers and sellers. It is determined essentially by the supply and demand for whatever is being traded. In such a market, competition and perfect

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