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basis risk in swaps

A

akashgoy

Member
Hi,

Can anyone please help me with an example for the statement given on pg 6 Chapter 19.

" if the swap interest rate curve moves differently to the government bond interest rate curve , this can create a basis risk which could lead to a mark to market loss"

Q. Lets say we have liabilities at time =1,2,and 3.These liabilities are discounted using government bond interest rate curve?
Swap floating payments will be based on the LIBOR and we receive fixed payments to pay the liabilities So the Basis risk is the difference between the government bond curve and LIBOR?
We are uncertain the spread between them might increase?
so this might increase/dec liabilities and the fixed payments received from swap may not be enough?
 
Hi,
Can anyone please respond to my query? Would highly appreciate it.
Thanks in advance.:)
 
Hi akashgoy,

Yes, that's precisely it. You've already answered your own question (very well!). If we are hedging interest rate changes using a slightly different set of interest rates to those we are trying to hedge, we introduce basis risk. The hedge relies on the swap interest rate curve moving in the same way as the government bond interest rate curve. If they do not, there is a chance that the difference between the two (the basis) will adversely affect us. Of course, we may benefit from there being a basis, but the point is that we have introduced a risk,

Good luck!
John
 
I just had 1 doubt . How does the basis affect us ? ( an example )
Do we mean the net cashflow from swap ( fixed - floating ) vs liabilities ?
 
And , are we receiving floating payment to pay liabilities or fixed payment leg of the swap? ( in context to the doubt)
 
Hi akashgoy,

Basis risk example

Let's say we have entered a receiver swap to hedge some particular liabilities. So, we receive fixed interest of 5% of £1m nominal each year and pay floating. We may enter this if our assets (value £1m) move with interest rates but our liabilities are a fixed amount of 50,000 pa. Whatever interest rates do, we are covered because we just swap whatever we've earned on the £1m for £50,000 each year and pay our liabilities. However, if the "interest rates" used to calculate the floating side of the interest rate swap are different to the ones that we're actually earning on our assets, we could lose out. For example, if our assets earn 5.6% (£56,000) as per the government bond curve, but LIBOR is 5.7%. We will have to swap £57,000 with £50,000 as part of the swap and we will lose £1,000.

Of course, if LIBOR is 5.5%, we gain £1,000. But the point is that any slight difference between LIBOR and the government bond curve will open up a risk, a risk that we call "basis risk."

Good luck!
John
 
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