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CMA Final · Risk Management in Banking and Insurance · Interest Rate Risk Management

In the context of interest rate risk in the banking book, 'basis risk' arises when:

Basis risk arises when a bank's assets and liabilities reprice against different benchmark rates that do not move together, so the spread between them changes even when overall rates are stable. Prepayment relates to option risk, curve twists to yield curve risk, and default to credit risk.

  1. AA bank's assets and liabilities reprice on different benchmark rates that do not move in stepCorrect
  2. BCustomers prepay loans when market rates fall
  3. CThe yield curve changes its shape through a twist
  4. DA borrower defaults on interest payments

Explanation

Basis risk arises when assets and liabilities are priced off different benchmarks, for example a loan linked to the repo rate funded by deposits linked to a term deposit rate. The spreads between these benchmarks can change even if the general rate level is stable. Prepayment is option risk and yield curve twist is yield curve risk, while default is credit risk.

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