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Published: 7th November 2008 by William Webster
Basis risk.pdf (120kb)
Note: Basis risk occurs when you pay one interest index and receive another. The following looks at just one aspect of a particular type of basis risk. The reference currency is GBP. Similar issues occur for retail institutions whose base currency is EUR or USD.
The London Interbank Offered Rate (Libor) has been used for over two decades as a reference rate for both cash and derivative transactions. It is currently under the spotlight with many commentators questioning its validity as banks have been rumoured to being paying interest rates in excess of Libor to secure funding.
Whether Libor suffers demise remains to be seen. But the fact that it trades significantly higher than the Bank of England's target rate, Bank Base Rate (BBR), poses some serious issues for senior management. The following explains why you should not ignore basis risk.
Basis risk naturally occurs in the balance sheets of many firms.
In normal market conditions basis risk is often overlooked, the index you receive is assumed to be correlated to the index you pay and the risk is regarded as small.
Then just when you considered conditions benign it strikes. Basis risk gives you gains or losses dependent on the structure of your balance sheet. In many cases the outcome is largely one of luck rather than judgment.
If you have a mixture of wholesale and retail assets and liabilities it is very likely you will be affected.
Consider a UK bank or building society. The firm has lent money to customers in the form of fixed rate mortgages. There are two potential sources of funding, wholesale and retail.
Suppose variable rate (administered rate) retail deposits provide the funding. If interest rates increase the cost of funding will rise but the mortgage rate is fixed. Most firms hedge this risk using interest rate swaps. They pay fixed interest on the swap and receive 3 month Libor.
The net position is one of receiving Libor and paying BBR (or a BBR linked rate). The interest rate risk appears to be hedged but is it? (See diagram below).
Recently 3 month Libor has been trading at a substantial premium to Base rate.
On 20th June 2008 3 month Libor was 5.95% whilst Base rate was 5.00% a differential of 95 basis points. Historically this is unusual the differential is normally in the range of 10 to 20 basis points with the gap often narrowing when markets are expecting rate cuts.
Why is Libor so high? It's the fall out from the credit crunch. Banks are finding it hard to borrow wholesale money, many markets are closed and the interbank market is at best difficult.
For a firm receiving Libor and paying Base rate (as in the example) this leads to a substantial benefit. A gain equivalent to £9.5m per annum for every £1 billion hedged. (Treasury or retail lending performance is enhanced depending on internal transfers). In the current environment any windfall gain is welcome. So what's the problem?
It's an issue of dependence. It is impossible to say with any certainty how long you can rely on this additional revenue. It is largely dependent on confidence in the financial system. As long as banks find it difficult to borrow Libor rates will probably remain elevated.
If you have senior management responsibilities you need to ask a few questions.
Your risk management department should be able to answer the first two questions by providing some straightforward explanations with the accompanying metrics.
Let's cut to the interesting stuff. Suppose you are running a significant basis risk what are the implications?
Basis risk can be managed with basis swaps. A basis swap exchanges one interest index for another. It's not the most liquid market but your dealers will be able to provide more information on maturity and pricing. In our earlier example if the bank decided to hedge it would pay Libor on the swap and receive Base rate.
You may be in for a surprise. Depending on prevailing prices and maturity, the swap may allow you to exchange Libor for Base rate plus a premium or margin of between 40 and 60 basis points. This is historically high (see diagram below). In effect you exchange the uncertain premium (of 90 bp) for a known premium (of 40bp) for a predetermined period of time. Is that hedge worth putting on?
If you find a decision difficult to make spare a thought for competitors that are more reliant on wholesale funding. Your windfall gain is their windfall loss.
A bank that pays Libor to borrow and then lends to retail customers on a variable rate basis (Base rate linked) is in a difficult situation.
Libor has increased relative to Base rate. Every time the bank refinances or reprices its variable rate liability margins shrink. Either the cost is passed on to the customer or earnings are depressed.
Little wonder that mortgage lending rates have been increasing.
14th October 2009
Gap reports show you the interest rate risk you are running in your balance sheet. They put the assets and liabilities into time buckets in accordance with their interest rate repricing. From this simple approach you can obtain a table or graph of the risk being run. This normally includes a profit and loss figure that results from moving the yield curve. Gap limits are also applied in order to keep the interest rate exposure within risk tolerence. Gap reports aren't new; they are widely used and have both strengths and weaknesses. Let's find out more.
Learn about the following: What basis risk is. How basis risk can affect you. How basis risk can be measured. How basis risk can be hedged. The problems with basis swaps.
16th March 2011
Basis risk - an update It's a salutary fact that the regulator has identified that firms that run relatively large basis risks are more prone to margin compression. That's because excessive basis risk reduces your control over the balance sheet and calls into question your risk management and governance. Ask a trader about basis risk and they will tell you it is to do with ineffective hedging. You may think of it as the risk between Libor and Bank rate. The fact is basis risk means different things to different people. So let's define it. In the following article basis risk is "the degree of control you have over the margins in your balance sheet". This may seem an unusual definition but all will become apparent.
28th September 2020
This risk is still very much alive, so how do we form judgement on what our risk appetite should be? I’ll try and answer this by considering three things.
BPV is a method that is used to measure interest rate risk. It is sometimes referred to as a delta or DV01. It is often used to measure the interest rate risk associated with swap trading books, bond trading portfolios and money market books.