Interest rate basis risk and Libor transition

Paul Newson

This chapter will expand upon the topic of basis risk, which was briefly introduced in Chapter 3. Basis risk can be a significant risk for many banks, but is one that standard gap and value approaches will usually miss as, in effect, they focus solely on the date when items will re-price as opposed to how much they might re-price on that date. Two sub-types – external basis and currency basis – will be examined in turn, followed by a brief summary of the possible impacts of Libor transition.


External reference rate basis risk describes the risk arising from the fact that different items, or products, on a bank’s balance sheet, even if perfectly matched in terms of re-pricing maturity, may nevertheless still re-price by different amounts because they are linked to different external rate indexes (such as Sonia and BBR).


Consider a bank that lends £100 million for five years at a variable rate always 2% higher than BBR, and funds this at Sonia. BBR and Sonia are both currently at 3%, so the bank may be reasonably considered immune from changes to the “general” level of interest rates changes, provided any change is

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