Distinguish between basis risk and yield curve risk in interest rate risk management. Explain using examples.

Expert Solution

Yield-curve.risk. arises. from variations. in the. movement. of interest. rates across. the. maturity. spectrum. It involves. changes. in the relationship. between. interest. rates of different. maturities of. the same. index. or market. The. relationships. change when. the shape. of the yield. curve for. a given. market. flattens, steepens, or. becomes negatively. sloped. during .an interest. rate cycle. Yield. curve. variation. can. accentuate. the risk .of a .bank’s position. by .amplifying. the effect. of maturity .mismatches. Certain .types of .structured notes. can be .particularly vulnerable .to changes. in the shape .of the .yield curve. For .example, the .performance .of certain types of structured .note .products, such .as dual. index notes, is. directly. linked to. basis and .yield curve. relationships. These .bonds have. coupon. rates .that are determined. by the difference. between market. indices, such. as the constant- maturity. Treasury. rate and. Libor. An. example .would be a .coupon whose .rate is .based on the following. formula: coupon. equals 10-year CMT .plus 300 basis. points .less .three-month .Libor. Since .the .coupon on this. bond .adjusts. as interest rates. change, a bank .may incorrectly. assume that .it will always .benefit if interest. rates. increase.

Basis. risk arises. from a. shift in the .relationship of the. rates in different. financial markets. or on .different. financial. instruments. Basis. risk occurs. when market. rates for. different. financial. instruments. or the indices. used .to price .assets and. liabilities, change. at different. times or .by different. amounts. For example, basis. risk occurs. when the. spread between. the three-month Treasury. and the .three-month. London. interbank. offered. rate (Libor) changes. This. change. affects. a bank’s current. net interest. margin. through changes. in the. earned/paid spreads. of instruments. that are being. repriced. It also. affects the. anticipated. future cash. flows. from. such instruments, which. in turn. affects the. underlying net. economic value. of the bank. Basis. risk can. also be. said to include. changes. in the relationship. between managed. rates, or rates. established. by the. bank, and. external rates. For. example, basis. risk may. arise because. of differences. in the prime. rate and a. bank’s offering. rates on various. liability. products, such. as money. market deposits. and savings. accounts. Because. consumer. deposit rates. tend to lag. behind increases. in market. interest rates, many. retail banks may. see an initial. improvement in their net. interest margins. when rates are. rising. As rates. stabilize, however, this. benefit. may be offset. by repricing. imbalances. and unfavorable. spreads in other. key market. interest rate. relationships; and. deposit. rates gradually. catch up. to the. market.

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