This chapter introduces basic concepts of managing risk from interest rates. We summarize the fundamental concepts of interest rate theory, such as discount factors, bond pricing, forward rate, swap rate, and term structures of interest rates. Additionally, historical data on interest rates of markets are shown, and these data suggest to us that market uncertainty is an important factor in financial risk.
Next, we introduce several risk measures used to evaluate interest rate risk: sensitivity, convexity, and value at risk (VaR). And, we briefly explain three methods to measure the VaR: covariance VaR, historical VaR, and Monte Carlo VaR. Additionally, nested simulation is explained for risk assessment in a derivative portfolio. After considering the validity of VaR as a risk measure, we address coherent risk measures.
Keywords: Bond price, Bootstrapping, Coherent risk measure, Convexity, Covariance VaR, Discount factor, Discount rate, Expected shortfall, Fixed coupon bond, Forward LIBOR, Forward rate, Historical VaR, Implied forward rate, Interest rate risk, LIBOR, Monte Carlo simulation, Nested simulation, Real-world measure, Risk factors, Sensitivity, Value at risk (VaR), Swap rate, Yield curve, Tail risk, Term structure, Yield to maturity, Zero-coupon bond