What is interest rate risk? Explain the interest rate sensitivity policy and discuss its broad parameters

Interest rate risk refers to the potential for changes in interest rates to affect the value of an institution's assets and liabilities, or its overall financial position. This risk arises because changes in interest rates can impact the cost of borrowing, the return on investments, and the value of fixed-income securities. Interest rate risk can be a significant concern for financial institutions, particularly those that hold large portfolios of fixed-income securities or that engage in interest rate-sensitive activities, such as lending or borrowing.

The interest rate sensitivity policy is a framework used by financial institutions to manage the risk of changes in interest rates. Interest rate risk is the risk that changes in interest rates will impact the value of a financial institution's assets, liabilities, or cash flows. The interest rate sensitivity policy aims to reduce this risk by identifying and managing the institution's exposure to interest rate fluctuations.

The interest rate sensitivity policy typically involves four broad parameters:

1. Setting interest rate risk limits: Financial institutions set limits on the amount of interest rate risk they are willing to take on, based on their risk appetite, business objectives, and regulatory requirements. These limits can be expressed in terms of specific measures of interest rate risk, such as duration or economic value of equity.

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