Financial management principles and practices

Financial Management

Significance of Interest to the economy:

Interest rates keep on changing with the passage of time; the rates which were present a month ago are quite different from the current rates. This is because the interest rates change with the change in the growth of the economy. The expectations of lenders and borrowers regarding the future prices also affect the interest rates (Trainer, 2012).

The interest rates in U.S. are affected by the values of the dollar, by foreign interest rates and also by the close examination of the monetary policy actions which are taken by the Federal Reserve. In our market economy a great role is played by the interest rates. Interest rates work just like traffic signals. The way in which the signals direct the traffic on intersecting roads, similarly interest rates manage the flow of money to borrowers from savers. Usually in the fund movement, other intermediaries like banks and insurance companies are also involved (Trainer, 2012).

How risk is considered to business and economic activity

Fluctuating interest rates have great impact on the economic value and the earnings of the banks. This thus gives rise to two separate perspectives for the purpose of assessing the risk exposure of the banks with regards to interest rates (Risk Institute, 2012).

Earnings perspective:

Usually the focus is on the interest rates causing increase in earnings while analyzing them according to the earnings' perspective. Banks mostly prefer this methodology to calculate the interest rate of risk assessment. It is important that there must be variations in the earnings in order to know the interest rate risk analysis (Risk Institute, 2012).

The reason behind this is the reduction in earnings and unexpected losses which disturb the economic stability by not only reducing the capital of the organization but also devalue the position in the market (Risk Institute, 2012).

Economic value perspective:

The financial values of the bank's assets, OBS positions and liabilities are also affected by the variation in the market interest rate. That is why the shareholders and the management take the fluctuation in the market interest rates very seriously. An instrument's financial value can be given by assessing its current value of cash flows which are discounted to represent the market rates (Risk Institute, 2012).

The word extension in the banks dictionary means the current value of bank's remaining cash flows which are calculated by subtracting cash flows of liabilities from expected cash flows of the assets and then added to the net cash flows on OBS conditions. Thus, in financial value perspective, it is clearly observed that the net value of bank is directly influenced by the fluctuations recorded in the interest charges (Risk Institute, 2012).

Embedded losses:

In the above mentioned economic value and earning perspective the main focus was given on the change occur because of the fluctuation of interest rates that directly influence the financial institution's performance. While evaluating the changes recorded in interest rate risks, bank must take a look on the past interest rate values that have affected the future performance (Risk Institute, 2012).