Chapter 31: Interest Rate Risk Management (CAIIB – Paper 2)
1. What is the primary objective of interest rate risk management in banks?
A. Maximizing short-term profits only
B. Avoiding all types of credit risk
C. Protecting the bank’s net interest income and economic value from interest rate fluctuations
D. Increasing the capital adequacy ratio
Interest rate risk management aims to safeguard the bank's net interest income and economic value against losses arising from changes in interest rates.
2. Which of the following is NOT a source of interest rate risk for a bank?
A. Repricing mismatch between assets and liabilities
B. Branch expansion to new locations
C. Yield curve movements
D. Options embedded in financial products
Interest rate risk arises from factors like repricing mismatches, yield curve shifts, and embedded options, but branch expansion is unrelated to interest rate risk.
3. Which type of interest rate risk results from the difference in timing between asset and liability repricing?
A. Repricing risk
B. Basis risk
C. Credit risk
D. Operational risk
Repricing risk arises when assets and liabilities reprice at different times, affecting net interest income.
4. Basis risk in interest rate management occurs when:
A. The bank defaults on a loan
B. The yield curve shifts upward
C. All deposits have the same interest rate
D. Changes in interest rates of different instruments do not move perfectly together
Basis risk arises when different interest-bearing instruments react differently to rate changes, leading to mismatches in cash flows.
5. Which of the following instruments can help a bank hedge against interest rate risk?
A. Equity shares of another bank
B. Interest rate swaps and futures
C. Fixed deposits without repricing
D. Bank’s branch expansion
Banks use derivatives such as interest rate swaps, futures, and options to hedge against fluctuations in interest rates.
6. What is the main effect of interest rate risk on a bank’s financial statements?
A. Changes in net interest income and economic value of equity
B. Increase in customer deposits automatically
C. Reduction in operational expenses
D. Changes in bank branch locations
Interest rate risk affects both net interest income and the economic value of the bank’s equity, influencing overall financial performance.
7. What is the primary effect of rising interest rates on a bank with more fixed-rate assets than liabilities?
A. Increase in net interest income
B. No impact on income
C. Decrease in net interest income
D. Increase in operational cost
If a bank holds more fixed-rate assets than liabilities, rising rates increase funding costs relative to asset returns, reducing net interest income.
8. Which of the following is a direct effect of interest rate risk on a bank’s balance sheet?
A. Change in customer branch visits
B. Variation in the economic value of equity (EVE)
C. Increase in non-performing assets automatically
D. Improvement in IT infrastructure
Interest rate changes impact the present value of assets and liabilities, thereby affecting the economic value of equity (EVE) on the balance sheet.
9. Which method measures interest rate risk by comparing the timing of asset and liability re-pricing?
A. Gap analysis
B. VaR (Value at Risk)
C. Credit scoring
D. Operational risk assessment
Gap analysis evaluates interest rate risk by examining mismatches in the timing of asset and liability repricing, helping manage net interest income risk.
10. Duration Gap measures:
A. Difference between interest rates of two banks
B. Number of days until loan repayment
C. Gap between customer deposits and advances
D. Sensitivity of the bank’s net worth to changes in interest rates
Duration Gap measures how the economic value of a bank’s assets and liabilities respond to interest rate changes, indicating the potential effect on net worth.
11. Value at Risk (VaR) in interest rate risk measurement estimates:
A. Future customer deposit growth
B. Maximum potential loss in a portfolio over a specified period and confidence level
C. Interest rate offered on term deposits
D. Number of non-performing assets expected
VaR provides an estimate of the maximum potential loss due to interest rate movements in a portfolio for a given time horizon and confidence level.
12. Which of the following is a key assumption while using gap analysis for measuring interest rate risk?
A. All assets are variable rate
B. Interest rates remain constant
C. Repricing occurs at discrete intervals and rate changes are parallel
D. Customer deposits are non-interest bearing
Gap analysis assumes discrete repricing intervals and parallel shifts in interest rates to estimate the effect on net interest income.
13. Which of the following is a quantitative technique to measure interest rate risk?
A. SWOT analysis
B. Duration and gap analysis
C. Customer feedback surveys
D. Marketing mix modeling
Duration and gap analysis are widely used quantitative techniques to measure interest rate risk by assessing the sensitivity of assets and liabilities to interest rate changes.
14. What is the main purpose of using interest rate swaps as a risk management strategy?
A. To increase operational efficiency
B. To fund branch expansion
C. To hedge against adverse movements in interest rates
D. To reduce customer complaints
Interest rate swaps allow a bank to exchange fixed and floating rate cash flows, mitigating the impact of interest rate fluctuations on net interest income or economic value.
15. Which of the following strategies can a bank adopt to reduce interest rate risk?
A. Increase exposure to high-risk loans only
B. Avoid all derivative instruments
C. Ignore repricing mismatches
D. Use gap management, duration matching, and hedging instruments
Banks control interest rate risk using strategies like gap management, duration matching, and derivatives to hedge exposures.
16. Stress testing in interest rate risk management helps banks to:
A. Reduce operational costs
B. Assess potential losses under extreme interest rate scenarios
C. Increase the number of customer accounts
D. Avoid regulatory reporting
Stress testing evaluates how extreme movements in interest rates could impact a bank’s financial position, helping in risk mitigation planning.
17. In controlling interest rate risk, what is the purpose of duration matching?
A. To increase branch network coverage
B. To adjust loan interest rates frequently
C. To align the sensitivity of assets and liabilities to interest rate changes
D. To reduce operational staff
Duration matching ensures that the weighted average duration of assets and liabilities is aligned, minimizing the impact of interest rate changes on net worth.
18. Which of the following is a limitation of gap analysis in measuring interest rate risk?
A. It predicts customer behavior accurately
B. It accounts for all embedded options
C. It considers all types of market risk
D. It assumes parallel shifts in interest rates and ignores non-linear effects
Gap analysis simplifies interest rate risk by assuming parallel rate shifts and may not fully capture the impact of complex instruments or non-linear changes.
19. Who is primarily responsible for overseeing interest rate risk management in a bank?
A. Branch Operations Manager
B. IT Department
C. Asset-Liability Committee (ALCO)
D. Marketing Department
The Asset-Liability Committee (ALCO) is responsible for monitoring, controlling, and supervising interest rate risk and ensuring that bank policies are followed.
20. Which regulatory body provides guidelines on interest rate risk management for banks in India?
A. SEBI
B. Reserve Bank of India (RBI)
C. Ministry of Finance
D. IRDAI
The Reserve Bank of India (RBI) provides comprehensive guidelines on managing interest rate risk, including measurement techniques and reporting requirements.
21. What is the main purpose of internal control systems in interest rate risk management?
A. To increase the number of loans
B. To automate customer service
C. To reduce marketing expenses
D. To ensure adherence to policies, monitoring, and risk limits
Internal controls help ensure that the bank adheres to its risk management policies, stays within limits, and monitors interest rate exposures effectively.
22. Which of the following reports is typically used for supervision of interest rate risk?
A. Branch daily cash report
B. ALM (Asset-Liability Management) report
C. Customer complaint report
D. Staff attendance report
ALM reports provide detailed information on the bank’s asset and liability positions, interest rate gaps, and exposures for effective supervision.
23. What is the key role of RBI in supervising interest rate risk in banks?
A. Providing loans to banks
B. Marketing banking products
C. Setting guidelines, monitoring compliance, and conducting inspections
D. Hiring staff for commercial banks
RBI supervises banks by issuing guidelines on interest rate risk, monitoring adherence, and conducting inspections to ensure sound risk management practices.
24. What is one of the key controls that banks implement to manage interest rate risk?
A. Increasing the number of branches
B. Reducing IT expenditure
C. Ignoring regulatory reporting
D. Establishing risk limits and monitoring gaps regularly
Banks control interest rate risk by setting internal risk limits, performing regular gap analysis, and reviewing exposures to ensure they stay within approved thresholds.
25. Which of the following is considered a sound practice in interest rate risk management?
A. Ignoring interest rate fluctuations in long-term planning
B. Regularly monitoring gaps, duration, and exposures
C. Relying solely on past interest rate trends
D. Avoiding the use of hedging instruments
Sound practices include continuous monitoring of gaps, duration, and exposures, ensuring proactive management of interest rate risk.
26. What is an important element of corporate governance in managing interest rate risk?
A. Expanding branch network rapidly
B. Offering high-yield deposits without risk assessment
C. Ignoring regulatory guidelines
D. Ensuring oversight by ALCO and board-level committees
Corporate governance ensures that the bank’s board and ALCO oversee interest rate risk policies and approve strategies to mitigate exposures.
27. Which of the following is a recommended practice for stress testing interest rate risk?
A. Using only historical interest rates without hypothetical scenarios
B. Ignoring impact on equity value
C. Including extreme but plausible rate changes to assess potential impact
D. Avoiding the use of derivatives
Effective stress testing simulates extreme but plausible rate movements to understand the potential impact on net interest income and economic value.
28. Which of the following is a key element of a robust interest rate risk management framework?
A. Focusing only on short-term assets
B. Clear policies, defined risk limits, monitoring, and reporting
C. Avoiding use of derivatives entirely
D. Ignoring regulatory inspections
A sound framework includes documented policies, defined limits, regular monitoring, and reporting to manage interest rate risk effectively.
29. Why is diversification of assets and liabilities considered a sound interest rate risk practice?
A. It eliminates operational risk completely
B. It ensures higher short-term profits only
C. It reduces the impact of rate fluctuations on the overall portfolio
D. It increases branch network
Diversification across assets and liabilities helps spread risk, reducing sensitivity to interest rate changes in any single instrument or segment.
30. Which of the following best describes a proactive approach to sound interest rate risk management?
A. Reacting only after losses occur
B. Ignoring ALCO recommendations
C. Focusing on marketing instead of risk
D. Continuously monitoring risk, conducting stress tests, and taking preventive measures
Proactive management involves continuous monitoring, regular stress testing, and implementing preventive strategies to minimize interest rate risk.
31. What is the main objective of RBI’s draft guidelines on IRRBB?
A. To increase branch expansion
B. To eliminate operational risk completely
C. To strengthen banks’ interest rate risk management in the banking book
D. To promote foreign exchange trading
RBI’s draft guidelines aim to ensure banks effectively measure, monitor, and control interest rate risk arising in the banking book.
32. According to RBI draft guidelines, banks are required to:
A. Focus only on foreign currency assets
B. Ignore duration of deposits
C. Avoid using derivatives entirely
D. Measure, monitor, and control IRRBB exposures using internal models
RBI emphasizes that banks should adopt robust measurement, monitoring, and control frameworks, including internal models, for IRRBB.
33. Which of the following risk metrics is suggested by RBI for measuring IRRBB?
A. Operational risk ratio
B. Economic value of equity (EVE) sensitivity and net interest income (NII) sensitivity
C. Branch efficiency index
D. Customer satisfaction score
RBI’s guidelines recommend using EVE and NII sensitivities as key metrics to assess interest rate risk in the banking book.
34. According to RBI, which of the following should banks consider when managing IRRBB?
A. Only short-term market trends
B. Branch expansion plans
C. Both on- and off-balance sheet exposures and embedded options
D. Only operational risk factors
Banks are expected to consider all relevant exposures, including off-balance sheet items and instruments with embedded options, when managing IRRBB.
35. RBI’s draft guidelines recommend stress testing for IRRBB. What is the purpose of this?
A. To assess staff performance
B. To reduce operational costs
C. To increase marketing efficiency
D. To evaluate potential losses under extreme interest rate scenarios
Stress testing allows banks to assess the impact of extreme but plausible interest rate changes on their banking book, supporting effective risk management.
36. Which of the following is a key requirement for governance under RBI’s IRRBB draft guidelines?
A. Avoid reporting to senior management
B. Clear board and ALCO oversight, regular reporting, and independent validation of models
C. Delegating all risk decisions to branches
D. Ignoring interest rate shocks
RBI’s draft guidelines emphasize strong governance with board-level oversight, ALCO supervision, regular reporting, and independent validation of IRRBB models.
