How to Manage Risk like a Bank

By JT Martin

All kinds of investors face risks to their portfolios and investments. Without risks, investors would have no added return incentive for their money, and our common idea of investing would be gone. However, while risks are necessary to investing, being able to manage or minimize risks when possible is a very useful skill and is one that even individuals should understand when making investment decisions.

One of the kinds of risks that can be managed very well is interest rate risk. This risk comes from the possibility of changes in interest rates that affect the prices of certain assets and liabilities. Most people would think that interest rate risk would only affect large financial institutions like banks because they give out so many loans and do substantial borrowing that depend on interest rates, and those people are generally correct because they deal with so many assets and liabilities that are sensitive to changes in interest rates. However, this risk can affect investors of any kind and they should all know how to manage and limit their own interest rate risk through the techniques that are employed by financial institutions like banks.

One technique that gives your portfolio the title of “immunized” is known as maturity matching. Maturity matching is the strategy that a firm or individual should finance their assets and liabilities in a way that they mature at the same time, to ensure they are able to have the necessary coupon. For example, if someone knows they will need to pay maintenance on their car in five years at a cost of $5000, they could buy a five year zero-coupon bond with a face value of $5000 to ensure the funds to pay for the maintenance. This would be utilizing the concept of maturity matching in a very simple way, by matching the set amount required at at a later date with a bond that guarantees that amount of money maturing at the same date. However, maturity matching is by no means a perfect strategy for immunizing a portfolio. The maturity matching technique does not take into account the time-value of money which affects the value of future cash flows which many rate-sensitive assets and liabilities have.

The tactic that is considered much more effective at eliminating interest rate risk and immunizing a portfolio is known as duration matching. The duration of an asset or liability is the weighted average of the cash flows from that asset or liability. Duration is calculated by adding the present values of each cash flow divided by the total present value of the asset or liability and then multiplied by the time period it occurs in. Similarly to the maturity matching method, the duration matching technique is done by matching the duration of an asset with a corresponding liability to immunize the interest rate risk. The duration matching method allows for things like coupon bonds or multiple bonds to be matched with the same $5000 payment from the example from earlier.

This technique may seem odd or inconvenient for an individual investor to employ, but individuals do face interest rate risks just like large financial institutions, and immunization can protect investors of any size from interest rate risks. This is beacsue all investors have some amount of risk from changes in interest rates through their gap of rate sensitive assets and liabilities. The first step of the process of immunizing a portfolio for any investor is to find their duration gap, which is the duration of their rate sensitive assets minus the duration of rate sensitive liabilities. Then, the process of matching the durations of certain liabilities with corresponding durations of assets. This is where the individual investor is at a disadvantage when compared to institutions because rhe process of immunization can become costly for individuals to eliminate risks they do not even consider very impactful, while institutions have more resources and incentive to minimize all risks possible.

Immunization techniques like duration matching can be useful to individuals in managing portfolio risk and can be easily understood by more mindful and knowledgeable investors. Interest rate risk affects all sizes of investors, and while the risk may not be at the forefront of individuals’ minds, duration matching provides a viable technique for risk-averse investors. Immunization shows that strategies used by financial institutions can be employed by the everyday investor for their benefit.

Works Cited

https://xplaind.com/379132/duration-matching

https://bizfluent.com/info-8545985-importance-maturity-matching-principle.html