Basis risk: Difference between revisions
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1. | 1. ''Hedging''. | ||
Basis risk includes the risk of an unfavourable change in the relationship between the price of a derivative and the market value of an underlying asset or liability being hedged. | Basis risk includes the risk of an unfavourable change in the relationship between the price of a derivative and the market value of an underlying asset or liability being hedged. | ||
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2. | 2. ''Funding''. | ||
Basis risk also arises in bank funding. | Basis risk also arises in bank funding. | ||
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For example, a UK bank's mortgage assets might be priced by reference to BBR (the Bank of England's Official Bank Rate) plus a margin, while the bank's funding is priced at | For example, a UK bank's mortgage assets might be priced by reference to BBR (the Bank of England's Official Bank Rate) plus a margin, while the bank's funding is priced at SONIA (plus a margin). | ||
The bank's net interest income depends on the differential between BBR and | The bank's net interest income depends on the differential between BBR and SONIA. | ||
Basis risk - in this context - means the risk of adverse changes in the differential between BBR and | Basis risk - in this context - means the risk of adverse changes in the differential between BBR and SONIA. An adverse change might compress the bank's net interest income, or even result in losses. | ||
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* [[Hedge effectiveness]] | * [[Hedge effectiveness]] | ||
* [[Hedging]] | * [[Hedging]] | ||
* [[ | * [[Interest Rate Risk in the Banking Book]] (IRRBB) | ||
* [[ | * [[Location basis risk]] | ||
* [[Official Bank Rate]] | * [[Official Bank Rate]] | ||
* [[Reference rate]] | * [[Reference rate]] | ||
* [[SONIA]] | |||
[[Category:Financial_risk_management]] | |||
Latest revision as of 20:52, 10 November 2022
1. Hedging.
Basis risk includes the risk of an unfavourable change in the relationship between the price of a derivative and the market value of an underlying asset or liability being hedged.
For example resulting in a smaller profit being enjoyed on a hedging derivative, than the loss suffered on the underlying exposure.
Good hedge design therefore seeks to eliminate or minimise basis risk in the hedged position, so far as practicable.
2. Funding.
Basis risk also arises in bank funding.
It arises when the reference rates used for the pricing of assets and their funding are different.
For example, a UK bank's mortgage assets might be priced by reference to BBR (the Bank of England's Official Bank Rate) plus a margin, while the bank's funding is priced at SONIA (plus a margin).
The bank's net interest income depends on the differential between BBR and SONIA.
Basis risk - in this context - means the risk of adverse changes in the differential between BBR and SONIA. An adverse change might compress the bank's net interest income, or even result in losses.
