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

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).

PANEL 6.1 EXAMPLE 1

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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