Measuring and Managing Interest Rate and Basis Risk

Giovanni Gentili, Nicola Santini

Interest rate risk is the exposure of a bank’s financial situation to variations of interest rates. It is principally driven by the maturity mismatch embedded in the typical balance-sheet structure of banks.

This chapter will illustrate the main tools for measuring interest rate risk and provide hedging examples.

We first introduce the earnings and economic values approaches to measure interest rate risk, and then illustrate the regulatory treatment according to the Basel Committee framework before introducing basis risk.

Risk measurement techniques will be treated in depth, with a comparison of the relative strengths and weaknesses.

A framework for yield curve construction that takes into account the evolutions following the financial crisis (OIS discounting and importance of basis risks) is given. The chapter concludes with operational examples of hedging with swaps.11While credit spreads could also influence the net interest income and economic value of one bank, this chapter does not treat hedging of credit risk.

THE EARNINGS PERSPECTIVE AND THE ECONOMIC VALUE PERSPECTIVE

We can identify two possible perspectives for measuring and managing interest rate risk: the earnings

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