Fundamentals of Interest Rate Risk and the Banking Book

Paul Newson

This article was first published as a chapter in Interest Rate Risk in the Banking Book, by Risk Books.

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 – which is the objective of 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

Market risk – from the standpoint of a bank – is the risk that changes in market prices may impact negatively the financial well-being of that bank. 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