Interest rate risk represents the main risk faced by individuals, companies, and financial institutions. The risk can arise from both a decrease and an increase in interest rates. A change in interest rates can significantly impact the value of assets and liabilities that consist of future cash flows. In an unpredictable economic environment, effective management of interest rate risk is crucial for maintaining financial stability and achieving strategic goals.
To protect against this risk, larger companies and financial institutions primarily use derivative financial instruments. These are mostly interest rate swaps and interest rate options. This limits unexpected changes in interest rates and the associated risk. Since derivative financial instruments are considered more complex, investors need to be familiar not only with interest rate risk and the macroeconomic environment but also with some mathematical formulas and models that allow them to calculate the value of the instruments.
In the master’s thesis, we take a closer look at the relationship between interest rates and bond prices. The Vasiček and Hull-White models, which are used for predicting interest rates, are presented.
For trading derivatives independently, it is essential to understand the models for their valuation. Therefore, this master’s thesis presents models for the valuation of derivatives. In addition to the well-known Black-Scholes model, the shifted Black-Scholes model is mentioned, and the Bachelier model is described in more detail. Both models operate in a negative interest rate environment. By understanding valuation models, investors can make strategic decisions regarding the purchase of such financial instruments. However, creating a portfolio of derivatives introduces new risks, which are also associated with the underlying risk, the interest rate risk. Therefore, knowledge of the instruments, analysis, and precise calculations are necessary to achieve optimal risk reduction and increase financial stability.
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