Question

QUESTION 6

One reason for basis risk in an interest rate swap is that changes in the index on the variable rate portion of the swap may not be perfectly correlated with changes in the index on the balance sheet portion of the liabilities.

True

False

Answer 1

The given statement is True. A basis rate swap is a variable to variable rate swap where two companies swap their variable interest rates. This leads to a basis risk which means the variable/ floating rates of the two companies being affected by two different indices. So, the company may be paying the actual amount of variable interest using swap which is dependent on one index whereas in its books it would record interest at a different variable rate dependent on another index which may not perfectly correlate with each other as it is highly possible the two indices don't perfectly correlate.