Question

QUESTION 12

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

True

The underlying asset may not be hedged with the same instrument so change in value of underlying asset is different than change in the value of instrument

For example to hedge an2 year bond it's hedged by a treasury bill

So both instruments have different characteristics and the might not behave same at all times. Thus arising the basis risk

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Hope that helps.

Feel free to comment if you need further assistance J