Module: | MODULE D: BALANCE SHEET MANAGEMENT
Q574: Consider the following statements regarding the specific operational mechanics of Repricing and Basis Mismatches:
1. A classic foundational source of repricing risk occurs when an institution funds long-term fixed-rate loans with short-term deposits, exposing the bank to margin compression if borrowing rates rise.
2. Gap Risk functions as the primary and most common source of interest rate exposure, emerging directly from mismatches in the timing of repricing or maturity dates.
3. Basis Risk serves as a distinct vulnerability, arising when the interest rates of different assets and liabilities change in unequal magnitudes despite having identical repricing frequencies.
4. The core mechanism of Basis Risk essentially stems from the imperfect correlation in the adjustment of rates earned on specific assets, versus the rates paid on corresponding liabilities.
2. Gap Risk functions as the primary and most common source of interest rate exposure, emerging directly from mismatches in the timing of repricing or maturity dates.
3. Basis Risk serves as a distinct vulnerability, arising when the interest rates of different assets and liabilities change in unequal magnitudes despite having identical repricing frequencies.
4. The core mechanism of Basis Risk essentially stems from the imperfect correlation in the adjustment of rates earned on specific assets, versus the rates paid on corresponding liabilities.
✅ Correct Answer: C
Repricing Risk and Basis Risk form the foundational, most heavily monitored layers of a bank's interest rate exposure profile.
Repricing Risk (Gap Risk) is the primary driver of volatility, materializing simply because a bank's assets and liabilities do not mature or reprice simultaneously.
A textbook operational trap occurs when a bank originates 15-year fixed-rate housing loans and funds them using 1-year retail deposits.
If central bank policy rates rise sharply in year two, the bank must pay higher interest to retain the short-term deposits, but the yield on the 15-year loans remains locked, causing an immediate, severe compression of the Net Interest Margin (NIM). Basis Risk, however, is far more insidious.
It assumes that the repricing timing is perfectly matched, but the underlying benchmark reference rates move asynchronously.
For example, an asset might be pegged to a 6-month Treasury bill rate, while the liability funding it is pegged to a 6-month interbank offered rate.
If systemic liquidity tightens, the interbank rate might spike violently while the Treasury rate remains stable.
This imperfect correlation in the adjustment magnitudes destroys the spread profitability, acting as the core mechanism of Basis Risk.
A: The combination of Only 1, 2, and 4 is incorrect because it arbitrarily excludes statement 3, failing to recognize that Basis Risk fundamentally operates even when repricing frequencies are identical.
B: The combination of Only 2 and 3 is incorrect because it excludes statement 1, which correctly illustrates the classic long-asset/short-liability margin compression trap, and statement 4, which details the imperfect correlation mechanism.
C: All 1, 2, 3, and 4 is the correct answer.
Every statement perfectly aligns with established risk management textbooks, accurately delineating the operational mechanics and distinguishing the precise differences between timing-based Repricing Risk and correlation-based Basis Risk.
D: The combination of Only 1 and 4 is incorrect because it excludes statements 2 and 3, which provide the foundational definitions of Gap Risk and the situational context of Basis Risk.
Repricing Risk (Gap Risk) is the primary driver of volatility, materializing simply because a bank's assets and liabilities do not mature or reprice simultaneously.
A textbook operational trap occurs when a bank originates 15-year fixed-rate housing loans and funds them using 1-year retail deposits.
If central bank policy rates rise sharply in year two, the bank must pay higher interest to retain the short-term deposits, but the yield on the 15-year loans remains locked, causing an immediate, severe compression of the Net Interest Margin (NIM). Basis Risk, however, is far more insidious.
It assumes that the repricing timing is perfectly matched, but the underlying benchmark reference rates move asynchronously.
For example, an asset might be pegged to a 6-month Treasury bill rate, while the liability funding it is pegged to a 6-month interbank offered rate.
If systemic liquidity tightens, the interbank rate might spike violently while the Treasury rate remains stable.
This imperfect correlation in the adjustment magnitudes destroys the spread profitability, acting as the core mechanism of Basis Risk.
A: The combination of Only 1, 2, and 4 is incorrect because it arbitrarily excludes statement 3, failing to recognize that Basis Risk fundamentally operates even when repricing frequencies are identical.
B: The combination of Only 2 and 3 is incorrect because it excludes statement 1, which correctly illustrates the classic long-asset/short-liability margin compression trap, and statement 4, which details the imperfect correlation mechanism.
C: All 1, 2, 3, and 4 is the correct answer.
Every statement perfectly aligns with established risk management textbooks, accurately delineating the operational mechanics and distinguishing the precise differences between timing-based Repricing Risk and correlation-based Basis Risk.
D: The combination of Only 1 and 4 is incorrect because it excludes statements 2 and 3, which provide the foundational definitions of Gap Risk and the situational context of Basis Risk.