Managing basis risk

The purchase of credit protection through credit derivatives may not completely
eliminate the credit risk associated with holding a loan because the reference asset
may not have the same terms and conditions as the balance sheet exposure. This
residual exposure is known as basis risk. For example, upon a default, the reference
asset (often a publicly traded bond) might lose 25% of its value, whereas the
underlying loan could lose 30% of its value. Should the value of the loan decline
more than that of the reference asset, the protection buyer will receive a smaller
payment on the credit default swap (derivative) than it loses on the underlying loan
(cash transaction). Bonds historically have tended to lose more value, in default
situations, than loans. Therefore, a bank hedging a loan exposure using a bond as a
reference asset could benefit from the basis risk. The cost of protection, however,
should reflect the possibility of benefiting from this basis risk. More generally, unless
all the terms of the credit derivative match those of the underlying exposure, some
basis risk will exist, creating an exposure for the protection buyer. Credit hedgers
should carefully evaluate the terms and conditions of protection agreements to
ensure that the contract provides the protection desired, and that the hedger has
identified sources of basis risk.