Interest Rate Basis Risk

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.

Three sub-types – external basis, currency basis and tenor basis – will be examined in turn; the first two are reasonably straightforward, while the last is often misunderstood and requires a thorough awareness of what drives the shape of the yield curve; if this is unclear, the reader should refer to Chapter 2.


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 differently because they are explicitly or implicitly linked to different external rate indexes – for example, Libor and BBR.


Consider a bank that lends £100 million for five years at a rate always 2% higher than BBR, and funds this at one

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